Direct indexing is disrupting the $100 trillion asset management industry

There are plenty of ways advisors can build portfolios: buying low-cost ETFs, purchasing actively-managed mutual funds, or sometimes using a mix of both. 

Another emerging solution is direct indexing, which allows advisors to buy stocks of an index rather than funds. Many now see the $400 billion direct indexing industry as the next big thing since the ETF and mutual fund. 

Given the potential direct indexing has to reshape asset management, advisors and investors should know how it works. Here's what they need to know about direct indexing to stay relevant. 

Direct indexing breaks down index funds into their smallest component components, the individual stocks, allowing advisors to build a portfolio with single securities. Instead of owning an ETF that tracks the S&P 500, investors own all 500 stocks or a representative share of the index. By doing so, advisors can replicate the index's performance and tweak their clients' holdings in a way that traditional funds never could, optimizing for things like ESG exposure of taxes. 

The concept isn't new, though. Wealthy investors have long been able to access similar solutions through a separately managed account. But recent innovations like commission-free trading and fractional shares have helped lower the barriers, like high account minimums, that once stood in investors' way. 

Advisors can rest easy knowing that direct indexing won't fall by way of previous investing fads. A flurry of acquisitions already suggests that Wall Street sees the potential for this mix and match approach. For example, BlackRock plunked down over $1 billion in 2020 for direct indexing pioneer Aperio. More recently, Vanguard, JPMorgan, and Franklin Templeton made similar moves to break into the space. 

It's not just the acquisitions that validate what’s going on but the momentum in the space. In the first quarter of 2020, assets on direct indexing platforms had reached $400 billion, a three-fold increase from the previous two years. Although this still pales in comparison to ETFs and mutual funds, research from Cerulli Associates suggests that direct indexing represents the largest source of growth over the next 5 years. Direct indexers are expected to grow at an annual rate of 12.4% compared to 11.3% growth for ETFs and 3.3% for mutual funds. 

As financial planning expert Michael Kitces puts it, this next generation of growth in direct indexing won’t just go to traditional asset management. Instead, more money will pour into solutions borne from fintech, companies built with technology and financial services in mind. 

Direct indexing gives advisors the ability to build custom portfolios that reflect their client’s goals better than ETFs or mutual funds.

**1. Values-based investing: **Eighty-four percent of investors say they want the ability to tailor their investments to their values. The number increases to 90% among millennial investors.   Unfortunately, this recent enthusiasm has only bred more generic funds that don't truly represent the values embodied by ESG. Take the iShares ESG Aware MSCI USA ETF. The makeup of the widely-held ESG ETF looks a lot like the S&P 500, with similar overweight positions in Big Tech and even a head-scratching footprint in fossil fuel producers, a sector not known as the standard-bearer of green practices. 

With direct indexing, advisors can sell or exclude these potentially controversial holdings. There's no more searching for a fund that's close enough to clients' religious, ESG, or other beliefs. Just remove and replace the names that don't align with their values. 

2. Tax management: Direct indexing also gives advisors control over taxes without jeopardizing the risk-return profile of the index a client seeks to mirror. It becomes easier to perform stock-level tax-loss harvesting and even set capital gains limits. Stock-level tax-loss harvesting, which sells stocks at a loss to offset gains elsewhere in a portfolio, can deliver 100 basis points of tax alpha, the after tax returns investors receive from automated tax loss harvesting (TLH). ​​So come April, when it's time to file taxes, clients won't ask why they owe so much.  

3. Improved diversification: By holding single stocks, an advisor can also target holdings that fit their clients' risk factors. Suppose a client was granted stock options from an employer. A portion of their wealth rides on this one stock, and in the event the price tumbles, it puts their portfolio in jeopardy. Advisors can now remove those names without overhauling the index. 

However, advisors will need to find the right balance with all these customizations. Change too much, and the portfolio looks entirely different from the index. Change too little, and clients will hold an expensive index fund. Keep in mind that the average cost of a direct indexer ranges from 20 to 35 basis points, or somewhere between a passive ETF and a mutual fund. 

Advisors will also need to keep an eye on any changes in the index. When securities enter or leave the index, such as in a scheduled rebalancing, they must reflect those changes in a client's portfolio.

Direct indexing is just the first step in what will be a giant leap to provide everyday investors with custom portfolios once limited to the ultra-wealthy. Advisors, who want to meet clients where they are and not where asset managers allow themselves to go, should pay close attention.