The mirage of direct indexing

A rare free lunch?

Nicolas Rabener

Nicolas Rabener Finominal

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

The giants of the asset management industry are clearly intrigued by direct indexing and it is not hard to see why. The rise of exchange-traded funds (ETFs) has steadily eroded the management fees of mutual funds and of ETFs themselves, and with more than 2,000 US ETFs and 5,000 US equity 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 business areas and growing client interest in customised portfolios has not gone unnoticed.

Direct indexing should be an easy sell for the marketing machines of Wall Street: A portfolio can be fully customised to the client’s preferences by, for example, excluding any stocks that contribute to global warming or prioritising high-quality domestic champions. On top of that, tax-loss harvesting can be offered. And all of this in a fairly automated fashion using modern technology stacks at low cost.

Like many proposals in investing, direct indexing seems like a free lunch that is too good to pass on. But is it?

An overview of direct indexing

Although firms like Parametric have been offering direct indexing to their clients for decades, the market’s AUM really started to grow since 2015. Over the last five years, direct indexing’s AUM expanded from $100bn to $350bn. In part, this is due to the software-creation technology becoming cheaper and easier to use, which opened the field to new entrants. The surge has also been driven by millennials seeking personalised portfolios, often with a focus on environmental, social, and governance (ESG) considerations.

chart, line chart

Source: Morningstar via FT, FactorResearch

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

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

chart, bar chart

Source: Cerulli Associates, FactorResearch

The dark side of direct indexing

Direct indexing marketing materials emphasise that each client receives a fully customised portfolio. The copy might describe a unique, tailor-made, or bespoke portfolio: the grande, iced, sugar-free, vanilla latte with soy milk from Starbucks versus the traditional coffee from Dunkin’ Donuts.

What’s not to like about being treated like a high-net-worth 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 they consider undesirable from the universe of a benchmark index like the S&P 500 is doing exactly what every US large-cap fund manager is doing.

But a client who creates their own portfolio based on personal preference, even if a financial adviser manages the direct indexing software, probably won’t be better at stock picking or portfolio construction than a full-time Goldman Sachs or JPMorgan Asset Management fund manager. 

Worse, most professional money managers lag their benchmarks over the short and long term, whether they’re investing in US or emerging markets, small-caps, or niche equity sectors. The fees on direct indexing portfolios tend to be lower than for equity mutual funds, giving them a leg up, but investing based on personal choice is unlikely to outperform already poorly performing fund managers.

So direct indexing clients should not expect to match the market.

chart, bar chart

Source: Cerruli Associates, FactorResearch

The risks of tax-loss harvesting

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

Here, stocks with losses are sold when capital gains from profitable trades are realised, thus reducing the net tax liability. Practically stocks that were sold can only be bought back 30 days after the sale, which means that an investor needs to buy something else instead.

There are various arguments why the tax benefit is far lower in practice than in theory. Indeed, some maintain that the liability is only deferred rather than reduced.

Direct Indexing: The Unwrapping of ETFs

Regardless, managing an investment portfolio based on tax decisions is wrong in principle and carries significant risks, for example, selling losers at an inopportune time, say during a stock market crash. Typically, the worst-performing stocks rally the most during recoveries. So, if these have been sold off, the investor captures the full downside but only a portion of the upside. Furthermore, replacing losers with other positions changes the portfolio’s risk profile and factor exposure.

But the most critical case against tax-loss harvesting is that, like direct indexing, it is just more active management. Hendrik Bessembinder demonstrated that just 4% of all stocks accounted for almost all the excess returns above short-term US Treasury bonds since 1926. Most stock market returns come down to a handful of companies, like the FAANG stocks in recent years. Not having exposure to any of these in order to, say, maximise tax benefits, is just too risky a choice for most investors. 

chart, bar chart

Source: Professor Bessembinder, FactorResearch

Further thoughts

Investors have realised that active management is challenging and therefore allocated more than $8trn to ETFs. If you cannot beat the benchmark, invest in the benchmark. This may sound simple and a little boring but it is an effective solution for most investors. 

Direct indexing is the antithesis of ETFs and is a step backward for investors. Like ESG or thematic investing, it is no free lunch. Investors need to know that their choices come with a price. Since most investors have underfunded their retirements, they should aim to maximise their returns and avoid any unnecessary risks.

Fully customised portfolios have historically been the exclusive domain of high-net-worth clients. Perhaps they should remain so.

Nicolas Rabener is founder and CEO of FactorResearch

Featured in this article


No ETFs to show.