Direct indexing is hot. In October 2020, Morgan Stanley acquired asset manager Eaton Vance primarily for its direct indexing subsidiary Parametric. BlackRock followed a month later by buying Aperio, the second tallest player in space. This year, JPMorgan acquired OpenInvest in June, Vanguard took over partner JustInvest in Julyand in September, Franklin Templeton has 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 the management fees of mutual funds and ETFs themselves, and with over 2,000 US ETFs and 5,000 US stock mutual funds all based on a universe of only 3,000 stocks, there is little room left for additional products. The industry is looking for new revenue-generating lines of business and the growing customer interest in personalized wallets has not gone unnoticed.
Direct indexing should be an easy sell for Wall Street’s marketing machines: a portfolio can be fully customized to client preferences, for example by excluding all stocks that contribute to global warming or prioritizing national champions of high quality. In addition to this, a tax-loss harvest can be offered. And all of this in a fairly automated way using stacks of modern, low-cost technologies.
Like many investment propositions, direct indexing seems like a free lunch too good to pass on. But is it?
Introducing Direct Indexing
Although companies like Parametric have been offering direct indexing to their clients for decades, the AUM of the market has really started to grow since 2015. Over the past five years, the AUM of direct indexing has grown from 100 to $350 billion. This is partly because software-building technology has become cheaper and easier to use, which has opened up the field for new entrants. The rise has also been spurred by millennials seeking personalized portfolios, often focused on environmental, social and governance (ESG) considerations.
Assets under management (AUM) in direct indexing, in US billions
How strong is the momentum in the direct indexing space? Market research by Cerulli Associates in the first quarter of 2021 predicted higher AUM growth in direct indexing over the next five years than in ETFs, segregated managed accounts (SMAs), and mutual funds.
Of course, a cynic might argue that direct indexing isn’t much more than an SMA in a modern tech stack. That may be a good point, but that’s a discussion for another day.
Projected five-year growth rates of assets under management by product, in the first quarter of 2021
The dark side of direct indexing
Direct indexing marketing materials emphasize that each client receives a fully personalized portfolio. The copy can describe a unique, bespoke or bespoke portfolio: the large, iced, sugar-free, vanilla latte with soy milk from Starbucks versus traditional coffee from Dunkin’ Donuts.
What’s wrong with being treated like a wealthy UBS client? Everyone deserves a personal portfolio!
However, this pitch leaves one thing out. What is actually being sold is pure active management. A client who eliminates or underweights certain stocks he deems undesirable in the universe of a benchmark like the S&P 500 is doing exactly what all large-cap US fund managers do.
But a client who creates their own portfolio based on their personal preferences, even if a financial advisor runs the direct indexing software, is unlikely to be any better at stock picking or portfolio construction than a fund manager. Full-time Goldman Sachs or JPMorgan Asset Management.
Worse still, most professional fund managers lag their benchmarks over the short and long term, whether they invest in US or emerging markets, small caps or niche equity sectors. Fees on direct-indexed portfolios tend to be lower than equity mutual funds, giving them an edge, but investing based on personal choice is unlikely to outperform managers already underperforming funds.
Direct indexing clients should therefore not expect to match the market.
Equity mutual fund managers underperform their benchmarks
The risks of tax-loss harvesting
Although their portfolios may underperform, direct index investors still have access to another important feature: tax loss harvesting.
Here, stocks with losses are sold when capital gains from profitable trades are realized, thereby reducing net tax payable. Practically, shares that have been sold cannot be redeemed until 30 days after the sale, which means an investor has to buy something else instead.
Various arguments explain why the tax advantage is much lower in practice than in theory. Indeed, some argue that liability is only deferred rather than reduced.
Either way, managing an investment portfolio on the basis of tax rulings is a mistake in principle and involves significant risks, for example selling losers at an inopportune time, such as during a crash scholarship. Typically, the worst performing stocks rally the most during rallies. Thus, if these have been sold, the investor captures all the downside potential, but only part of the upside. Additionally, 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 is simply more active management. Hendrik Bessembinder demonstrated that just 4% of all stocks accounted for almost all of the excess returns over short-term US Treasuries since 1926. Most stock returns come down to a handful of companies, like FAANG stocks in recent years. Not being exposed to any of these in order, for example, to maximize tax benefits, is simply too risky a choice for most investors.
Shareholder wealth creation exceeding one-month U.S. Treasury bills, 1926 to 2016, trillion U.S. dollars
Investors realized that active management was difficult and therefore allocated over $8 trillion to ETFs. If you can’t beat the benchmark, invest in the benchmark. It may sound simple and a bit boring, but it is an effective solution for most investors.
Direct indexing is the antithesis of ETFs and represents a step backwards for investors. Like ESG or thematic investing, it’s not free. Investors need to know that their choices have a price. Since most investors have underfunded their retirements, they should aim to maximize their returns and avoid unnecessary risk.
Fully personalized wallets have always been the exclusive domain of wealthy clients. Maybe they should stay that way.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Aaron McCoy
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