Listen closely and you will hear whispers from some corners of ETF industry that direct indexing is set to replace ETFs within the next two decades. Where this is most prevalent is in the environmental, social and governance (ESG) space.

There is no doubt ESG investing is here to stay. One only has to take a glance at the flows into ESG ETFs last year to get an understanding of the change afoot. According to data from Morningstar, ESG ETFs accounted for over 51% of total ETF flows in Europe in 2021 as assets jumped to $278bn, 17.4% of the entire European ETF market.

The shift to ESG will only increase amid rising regulatory requirements and a more socially conscious investor base, especially in Europe.

While ESG ETFs have ballooned in popularity, there are limitations to their implementation. The main point being ESG is extremely subjective. One only has to look at the backlash to the European Union’s decision to include nuclear energy in its taxonomy – Austria and Luxembourg have taken the EU to court while Germany is vehemently against the move.

And this is at a government level. When diving deeper into individual investors, these views diverge even more to the point where each investor will have a slightly different view of what securities should – and should not – be included in their portfolio.

As a result, incorporating a rules-based strategy such as an ETF will never satisfy anyone as it leaves investors beholden to the views of ESG data providers and indexing firms such as MSCI.

This is where the power of direct indexing comes into play. Investors can customise the underlying holdings to exactly align their values with their portfolio.

It could be a game-changer for the ESG space as investors currently need to rely either on an active manager who is subject to the usual risk of style drift – a particularly pointed issue with ESG – or an ETF which is limited in its ESG approach.

As David Jervis, global client officer at direct indexing investment platform C8 Technologies, told ETF Stream: “It is like building your menu to match your values. Now clients are saying ‘we will define ESG as we want and build something that actually fits our charter’.”

This issue will become particularly pertinent amid the $24trn wealth transfer to millennials who tend to be more socially conscious and will want to ensure their investments are aligned with their core values including sustainable metrics.

As Amrita Nandakumar, president of US-based Vident Investment Advisory, said: “There are people who would like to include exposure to certain types of industries and definitely exclude others. Why not give investors the opportunity to customise that exposure based on their core beliefs?”

This is not to say the ETF market’s role in ESG is going away anytime soon, however, understanding and taking advantage of the benefits of direct indexing from an ESG perspective will benefit all in the long term.

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