Direct indexing is the talk of the town; it seems nearly impossible to read industry news or social media without hearing the phrase. For some, the merits of direct indexing may seem clear. However, many financial pros are wondering if this is the next big thing or the last big hype. My vote is the former, but we are still very early in the stages of adoption and there are some wild claims being made. I think direct indexing is unlikely to completely displace the ETF or mutual fund. It will simply find a spot alongside these structures and others, each providing their own advantages for different applications.
The idea is elegantly simple: own all the securities of an index directly in your account, rather than through a mutual fund or ETF share. It combines the benefits of low-cost passive investing with the advantages of SMA structure. This is not a new strategy as institutions have employed similar techniques for decades and probably longer. The large list of securities provides the diversification investors typically gain from pooled investment vehicles at a low management fee with the objective of simply matching the benchmark risk/return. The managed account structure allows trading services like rebalancing, tax loss harvesting, cash management to be performed specifically for the individual. Studies have shown tax aware trading may add approximately 1% per year in additional returns vs. a broad market benchmark. Additionally, the index portfolio may be altered to suit the client’s objectives and constraints. For example, an investor may choose to reduce the holdings of companies in the industry they work or express strong values-based convictions.
Like most financial management techniques which move from the obscure corners of institutions and family offices to the mainstream, this one is being driven by advances in technology. Rebalancing, tax loss harvesting, and Unified Managed Account reporting software have matured together, allowing once extremely laborious processes to be completed very easily and efficiently across many client accounts. Add in no-transaction-fee trading and fractional shares, and the process becomes available to virtually any investor. Since many wealth managements firms have upgraded their “tech stack” in recent years, introducing direct index services will not require a complete system overhaul for most firms. Some may need to have functionalities enabled to their existing systems; others may be pleasantly surprised to realize that they already possess full capabilities. The economics scale very well, and the potential benefits reaped by clients and the firm extend far into the future.
As adoption continues, the most common allocations to direct index portfolios will likely be in core equity positions. Diversified domestic large cap tends to be an incredibly difficult market to consistently produce meaningful alpha and many investors have already relegated that portion of the portfolio to low-cost beta. In model portfolio/ managed account format this beta can help achieve additional planning objectives. Mangers must balance tracking error from the index with opportunistic realized loss harvesting, ideally keeping the tracking error within a reasonable threshold while generating a net realized loss which may be applied to offset gains the client realizes outside of the direct index portfolio or carried forward.
While we are still in the first inning, I expect to see the technology and techniques continue to creatively evolve. For example, the short or inverse components of hedged and long/short index strategies may provide additional opportunities to tactically realize losses while lower turnover broad market indices provide a nice base for option overlay strategies. It will certainly be exciting to watch the innovation that takes place!