The Mirage of Direct Indexing


Direct indexing is hot. In October 2020, Morgan Stanley bought asset manager Eaton Vance primarily for its direct indexing subsidiary Parametric. BlackRock followed a month later with the purchase of Aperio, the second largest player in the space. This year, JPMorgan bought OpenInvest in June, Vanguard took over its partner JustInvest in July, and in September Franklin Templeton acquired O’Shaughnessy Asset Management (OSAM) and its direct indexing platform Canvas.

The giants of the asset management industry are clearly intrigued by direct indexing, and it’s not hard to see why. The rise of exchange-traded funds (ETFs) has steadily eroded management fees for mutual funds and ETFs themselves, and with more than 2,000 US ETFs and 5,000 US equity mutual funds, all based in a universe of only 3,000 stocks, there is little. space remains for additional products. The industry is looking for new areas of business that generate revenue and the growing interest of customers in personalized wallets has not gone unnoticed.

Direct indexing should be an easy sell for Wall Street’s marketing machines: A portfolio can be completely customized to a client’s preferences, for example, excluding stocks that contribute to global warming or prioritizing national champions of high quality In addition, tax loss harvesting can be offered. And all this in a fairly automated way using batteries of modern technology at low cost.

Like many investment propositions, direct indexing seems like a free lunch too good to pass up. But is it?

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An overview of direct indexing

Although companies like Parametric have been offering direct indexing to their clients for decades, the AUM of the market really started to grow in 2015. Over the past five years, direct indexing AUM expanded from 100 to 350 billion dollars. In part, this is because software-building technology is becoming cheaper and easier to use, opening the field to new entrants. The rise has also been driven by millennials seeking customized portfolios, often focused on environmental, social and governance (ESG) considerations.

Assets under management (AUM) in direct indexing, US billions

Chart showing AUM in direct indexation
Source: MorningStar via Financial TimesFactor Research

How strong is the push in the direct indexing space? A market research study by Cerulli Associates in the first quarter of 2021 predicted higher AUM growth in direct indexing over the next five years than in ETFs, separately managed accounts (SMAs) and mutual funds. investment

Of course, a cynic could argue that direct indexing is not much more than an SMA in a modern technology stack. That may be a fair point, but that’s a discussion for a different day.

Expected five-year AUM growth rates by product, as of Q1 2021

Chart showing projected five-year AUM growth rates by product (Q1 2021)
Sources: Cerulli Associates, FactorResearch

The dark side of direct indexing

Direct indexing marketing materials emphasize that each customer receives a fully customized portfolio. The copy could describe a unique, tailor-made, or customized portfolio: Starbucks’ large vanilla, iced, sugar-free, soy milk latte versus Dunkin’ Donuts’ traditional coffee.

What’s not to like about being treated like a high net worth UBS customer? Everyone deserves a personal wallet!

However, this field leaves one thing out. What really sells is pure active management. A client who removes or underweights certain stocks they consider undesirable from the universe of a benchmark such as the S&P 500 is doing exactly what every US large-cap fund manager does.

Piece for the T-Shape Teams report

But a client who builds his own portfolio based on personal preferences, even if a financial advisor manages direct indexing software, probably won’t be any better at stock-picking or portfolio-building than a manager of funds from Goldman Sachs or JPMorgan Asset Management full-time.

Worse, most professional money managers are lagging their short-term and long-term benchmarks, whether they’re investing in US or emerging markets, small caps or niche equity sectors. Fees for direct index portfolios tend to be lower than those for stock mutual funds, giving them an advantage, but investing based on personal choice is unlikely to outperform fund managers who already they have low performance.

Therefore, direct indexing clients should not expect to match the market.

Equity mutual fund managers underperform their benchmarks

Chart showing equity mutual fund managers underperforming their benchmarks
Source: FactorResearch

The risks of collecting tax losses

While their portfolios may underperform, direct index investors still have access to another important feature: tax loss harvesting.

Here, loss-making shares are sold when capital gains are realized from profitable operations, thereby reducing the net tax liability. Practically the shares that were sold can only be bought back 30 days after the sale, which means that an investor has to buy something else.

There are several arguments why the tax benefit is much lower in practice than in theory. In fact, some argue that liability is only deferred and not reduced.

Journal of financial analysts Current number mosaic

In any case, managing an investment portfolio based on tax decisions is wrong in principle and carries significant risks, for example, selling losers at an inopportune time, for example, during a stock market crash. Typically, worst-performing stocks rally the most during recoveries. Therefore, if they were sold, the investor captures all of the downside, but only a portion of the upside. In addition, replacing losers with other positions changes the risk profile and factor exposure of the portfolio.

But the most critical case against tax loss harvesting is that, like direct indexing, it’s just more active management. Hendrik Bessembinder showed that just 4% of all stocks accounted for almost all the excess returns over short-term US Treasuries since 1926. Most of the stock market’s returns come down to a handful of companies, like FAANG stocks in recent years. Having no exposure to any of these to, say, maximize tax benefits, is too risky an option for most investors.

Shareholder wealth creation in excess of one-month US Treasuries, 1926 to 2016, US trillion

Chart showing shareholder wealth creation in excess of one-year US Treasuries, 1926-2016, US trillion
Sources: Hendrik Bessembinder, FactorResearch

Additional thoughts

Investors have realized that active management is a challenge and have therefore allocated more than $8 trillion to ETFs. If you can’t beat the benchmark, invest in the benchmark. This may sound simple and a bit boring, but it is an effective solution for most investors.

Direct indexing is the antithesis of ETFs and is a step backwards for investors. Like ESG or thematic investments, it’s not a free lunch. Investors need to know that their options come at a price. Since most investors have underfunded their retirements, they should try to maximize their returns and avoid unnecessary risk.

Fully customized portfolios have historically been the exclusive domain of high net worth clients. Maybe they should stay that way.

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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images / Aaron McCoy

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Nicholas Rabener

Nicolas Rabener is the CEO of FactorResearch, which provides quantitative solutions for factor investing. He previously founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focusing on real estate across asset classes. He began his career working for Citigroup in investment banking in London and New York. Rabener holds a master’s degree in management from the HHL Leipzig Graduate School of Management, holds the CAIA charter and enjoys endurance sports (100 km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

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