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HomeMarketDirect Indexing Is Taking Off. Is It Really Better Than an ETF?

Direct Indexing Is Taking Off. Is It Really Better Than an ETF?

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For what’s a niche investment arena for mostly affluent investors, the direct-indexing space is getting crowded.

Morningstar recently launched a direct-indexing strategy, which comes on the heels of Fidelity Investments’ announcement it was expanding its suite of offerings. They join heavyweights BlackRock, Vanguard Group, Morgan Stanley, and a half-dozen others in the space.

Direct indexing lets investors customize an index, such as the S&P 500, by buying some of the underlying securities rather than an S&P 500 exchange-traded fund or mutual fund. The baskets seek to track the returns and risk of the target index, minus a select number of stocks or sectors.

There are two big selling points for direct indexing versus funds: personalization—being able to pick and choose holdings—and tax-loss harvesting. With a customized basket of index-tracking stocks, investors can sell individual securities instead of an entire fund, handy for investors in high-tax states with sizable taxable accounts.

Firm AUM (bil)
Morgan Stanley Investment Management $136
Goldman Sachs Asset Management 102
Northern Trust Asset Management 53
BlackRock 49
Fidelity Investments 29

Note: data as of June 30, 2022

Source: Cerulli Associates

Pinpointing that extra tax efficiency could challenge ETFs’ dominance as the tax-efficient vehicle of choice. Indeed, direct indexing is growing faster than its rivals. Cerulli Associates sees direct indexing experiencing a 12.3% compounded annual growth rate over the next five years, a faster growth rate than ETFs and mutual funds.

Of course, that growth comes from a low base, notes Tom O’Shea, research director at Cerulli. Direct indexing had $462 billion in assets under management as of the first quarter of 2022, and Cerulli forecasts it will reach $825 billion by 2026. Comparatively, ETFs have about a $7 trillion market share.

The strategy has advantages for certain investors, but not everyone. It’s complex, costs more than ETFs, and requires a commitment to indexing, and its current best-use cases may be limited to affluent investors.

Still, its growth rate appeals to an industry that has seen investment management fees compress over the years. David Botset, head of equity product management and innovation at Schwab Asset Management, says direct indexing may be where ETFs were a decade ago.

Old Strategy, New Tech

Direct indexing is similar to how investment firms traditionally customized separately managed accounts for their institutional clients. What’s new now are innovations such as commission-free trading, the ability to trade fractional shares, and robust algorithmic trading technology, making it feasible for firms to offer it to many more clients.

Rich Compson, head of wealth management at Fidelity, says the technology can give investors index-like returns even if clients don’t own every index component. For example, an investor might want to exclude
Microsoft
(ticker: MSFT) from their direct-index allocation because as an employee they already own shares. Compson says the algorithm doesn’t just swap Microsoft for
IBM
(IBM) but looks for stocks across different industries with similar return patterns, market capitalization, and earnings to Microsoft. Additionally, because trading is automated, it can harvest losses during volatile markets throughout the year, rather than just at year end, when most traditional advisors sell losing positions.

Values-based investors—and those who favor an ESG approach, for environmental, social, and governance factors—could benefit from direct indexing’s personalization as advisors can more finely tune portfolios to shun certain companies or sectors, while the algorithm finds suitable replacement stocks to track the investor’s chosen index.

Nate Geraci, president of the ETF Store, a wealth manager, says direct indexing is a better option versus ESG ETFs for those investors who hold very strong beliefs because the strategy is so targeted. “It does offer a very elegant solution to allow investors to express their personal preferences,” he says.

The strategy isn’t a whole portfolio solution, says Schwab’s Botset, but can be a core part of it. “What really makes direct indexing unique is…to not just make it tax efficient, but actually help generate losses that clients can use to offset gains in other parts of their portfolio,” he says.

Paying for Personalization

Direct indexing’s cost varies by firm, but it averages around 0.40% annually. That compares to passive ETFs that follow broad indexes such as the S&P 500 that cost less than 0.10% annually. The strategy is available mostly to financial advisors who have clients with $100,000 or more in assets, although Fidelity, Wealthfront, and a few others have vehicles available for self-directed investors with account minimums around $5,000.

Jon Foster, CEO of Angeles Wealth Management, uses direct indexing with his wealthier clients but doesn’t recommend it for small investors because it’s a complex strategy. As investors try to replicate an index, they may end up owning hundreds of individual companies, which may mean receiving hundreds of corporate statements.

“The small investor should run in the other direction,” Foster says. “It really needs to be part of a bigger overall financial strategy for a family of means.”

The tax angle may be overhyped, too, says Jason Escamilla, co-founder of ImpactAdvisor, who built his own direct-indexing platform for his ESG-focused and high-net-worth clients in California. It’s a long-term commitment to reap the compounding benefit of tax-loss harvesting, and it’s best for investors who will likely always have high capital gains to write off.

Investors who don’t have the long-term time frame to enjoy the tax benefits of direct indexing should stick to ETFs, Escamilla suggests.

“If you’re going to liquidate the portfolio in a few years to buy a house, you may be better off just buying an active ETF,” he says.

Lower-net-worth investors may run out of losses to harvest, too, both Foster and Escamilla say. Aggressive tax-loss harvesting lowers the cost basis of the portfolio, so when those stocks are eventually sold investors may receive higher capital gains. One way investors can avoid the capital-gains taxes would be to donate those assets to charity, Foster says.

While it’s called direct indexing, Geraci believes that’s misleading because the strategy tinkers with the index holdings. “That’s active management. And we know from historical data that making active decisions in a portfolio tends to detract from returns,” he says.

He also worries some advisors may use direct indexing as a way to retain clients, since it’s harder for the client to switch hundreds of stocks to another advisor. “I don’t think that’s a good reason to be using direct indexing as a fiduciary advisor myself,” he says.

Email: editors@barrons.com

Credit: marketwatch.com

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