Customized portfolios using direct indexing are one of the hottest trends in asset management. And the shops that have sold you off-the-shelf funds are now rushing to give you the tools to do it yourself.
Franklin Templeton became the latest firm to jump into the direct indexing market last month, announcing an agreement to acquire O’Shaughnessy Asset Management. OSAM runs about $1.8 billion in direct indexing strategies through its Canvas platform, which allows advisors to build customized exposures to asset classes through separately managed accounts.
Direct indexing gives clients broad exposure to an asset class, such as large-cap equities. But rather than buy a mutual fund or ETF, investors own the individual stocks that comprise an index. The customization comes in when advisors tweak which index components they buy – or don’t buy – and in what proportions.
Franklin joins a mix of established investment product providers scooping up direct indexing specialists. Morgan Stanley struck a deal to buy Eaton Vance and its Parametric custom index specialist about one year ago. Meanwhile, BlackRock’s buy of Aperio, JPMorgan Asset Management’s purchase of 55ip and OpenInvest, Vanguard’s acquisition of Just Invest, and even Morningstar’s deal for Moorgate Benchmarks all key in on the booming assets in personalized index portfolios.
Just last week, McKinsey & Co. predicted that by 2025 direct indexing assets could be more than double the $215 billion they represented in 2020.
Advisor adoption of direct indexing is fueled by a mix of demand for more tailored strategies for clients –whether to address tax concerns, over exposure or environmental, social and governance goals – and technology that takes some of the time and cost out of running custom portfolios. Hence, the arms race for direct indexing tools began, executives and analysts say.
Tax management is one of the biggest features direct indexing products. By holding the individual securities, an advisor can use tax-loss harvesting, among other tactics, to minimize overall the bill or address specific tax issues. FAs also can tailor portfolios to specific environmental or social concerns while maintaining the general risk and return profiles of the asset class.
Parametric has been personalizing indexes since 1992. But in the early-Internet age, direct indexing was hard and expensive. Hard because advisors had to gather all of the information from clients needed to set up the portfolios, then manage rebalancing and transactions. Expensive in that clients need to plunk down enough cash to hold dozens or even hundreds of securities in a portfolio, on top of the expense of running such a strategy.
That is where technology comes in. New tools, eithers for advisors to use themselves or provided by traditional separately managed account programs, allow managers and advisors to automate the setup and ongoing maintenance of custom indexes. That, in turn, allows advisors to handle more of customized indexes in their practices.
Combine these tools with fractional share trading capabilities available on (or coming to) RIA custody platforms, and advisors now can significantly shrink custom index investment minimums from $1 million or more down to $100,000 for tax-focused direct indexing options from Wealthfront, Charles Schwab and even Parametric.
What then of traditional index funds, like ETFs? While direct indexing is getting easier, it still can be complicated to replicate indexes like the small-cap Russell 2000 or international benchmarks that include less liquid securities, notes Fidelity in an explainer on its website. And when the stock market gets volatile, direct index managers may need to trade more, which increases the cost of managing such a strategy, it adds.
Ultimately, smaller investors, or investors who don’t have a lot of money in taxable accounts, may be better off with index funds or ETFs, Fidelity argues.