Technology providers push direct indexing into the mainstream

Investment firms are racing to provide access to direct indexing (DI) — a way of creating bespoke indices for individual clients — as demand rises for portfolios that are more personalised and tax efficient.

DI was previously restricted to affluent clients and their wealth managers, due to the higher costs involved. But, recently, developments in technology have brought customisable indices to a broader customer base. Firms are rushing in, acquiring new fintech partners and building out their DI offerings.

“There is a bit of a race on at the moment,” says Daniel Needham, president of wealth management at Morningstar. The index group purchased direct-indexing specialist Moorgate Benchmarks in September, following in the footsteps of other industry titans such as Vanguard, BlackRock and Morgan Stanley.

DI allows investors to tailor portfolios around their specific investment interests, choosing to include or exclude specific stocks, as well as weighting holdings according to their preferences. For example, they could specify environmental, social and governance (ESG) credentials — or value or momentum investing strategies.

But demand for DI is also being driven by its use as a tax tool. In the US, DI can deliver tax benefits, as it allows investors to reduce their tax liabilities through tax-loss harvesting: selling stocks that are losing value and matching the loss against gains, to reduce capital gains tax due on other investments.

“There is going to be an increase in demand for these services . . . Being able to personalise a portfolio at scale for an individual is pretty compelling — especially as people begin to express their personal values in their portfolios,” Needham says.

Around 20 per cent of retail investor accounts are held in DI products, according to research by Cerulli Associates. And the market share taken by customisable products is predicted to grow, with estimates suggesting they will account for more than 8 per cent of all assets under management by 2030.

As a result, there has been a land grab among large traditional managers to find partners who can help provide direct indexing solutions to clients.

BlackRock acquired Aperio in November 2020, while JP Asset management picked up OpenInvest in June 2021, in order to provide more customisable ESG offerings. Vanguard made its first acquisition in its history when it bought Just Invest in July 2021, a wealth management boutique that offers DI customisation.

DI’s assets under management have been growing rapidly in recent years, according to research by Morgan Stanley. In 2020, around $3.5bn was managed through DI. That figure is expected to grow an average of 34 per cent per year for the next five years to $1.5tn, from wealth manager demand alone.

A 2022 survey by the CFA Institute found DI was the most popular customisation tool among investors who had financial advisers, with 56 per cent saying they were interested in utilising them.

And customisation is in high demand. Eighty-two per cent of those surveyed said they were interested in increasing the personalisation of their investment products.

DI is particularly valuable in high-value portfolios invested across alternative solutions such as hedge funds, private equity and less liquid alternatives.

“In any of those instances, if the primary goal is to deliver alpha or outperformance, at the end of the day tax isn’t the primary consideration,” says Stephanie Pierce, chief executive of investment provider Dreyfus Mellon as well as exchange traded funds at BNY Mellon Investment Management. Investment losses can also be carried over from one year to the next to offset gains.

“If you know you’re going to have potential capital gains it’s nice to have something working for you all year that is designed to give you same return as market but also gives you tax offsets at the overall portfolio level,” she adds.

But DIY shops are pushing in as well, as retail brokers have raced to offer solutions to investors. In April, America’s largest retail brokerage, Charles Schwab, launched a DI product for customers, as part of a tax management offering. The broker built its own DI solution rather than partner with a provider. Another US brokerage, Fidelity, this year added 12,000 new jobs, it said as part of a push to expand into new areas such as DI.

Interest in DI has been catalysed by recent market performance. “We have gone through a decade long bull market in equities, so you have a large number of individuals who have made investments over time, and may hold funds that have made substantial gains,” notes David Botset, head of equity project management at Charles Schwab. “They can see the potential impact that taxes will have, and that has them increasingly looking for tax advantage opportunities in their accounts.”

In a choppy or falling market, investment losses create more opportunities for offsetting these large gains.

Dropping trading commissions also helped to make DI possible for more investors than just ultra-high net worth individuals, Botset adds.

“An industry that has, historically, been focused on pre-tax returns has started focusing on: what do these taxes mean and the implications,” says Liz Michaels, co-head of longtime player Aperio, which was acquired by BlackRock in February.

But, despite the hype around the offering, advisers say that DI is not for everyone.

“It’s the new thing, but it doesn’t mean that the old thing — exchange traded funds — aren’t the right answer for many many people,” Michaels says. “Tax loss harvesting only makes sense if you have capital gains elsewhere in your portfolio. It is a tremendously powerful tool for the people who need it, but it’s more complex than people realise.”