Smart beta direct indexing is set to become an important part of an investor’s toolkit, according to a report by Research Affiliates.

The report, entitled The Advisor’s Case for Smart Beta Direct Indexing, claimed there are a number of advantages to smart beta direct indexing including tax savings and a stronger alignment of investors with their personal beliefs and circumstances.

Direct indexing came into the spotlight earlier this year after Matt Hougan, chairman of Inside ETFs, and Dave Nadig, managing director of ETF.com, predicted it would be the next big disruption.

Direct indexing moves beyond the fund structure and enables investors to customise indices based on their values, employment situation and tax loss harvest.

For example, someone at Apple may not want to own the company in their portfolio so with direct indexing they are able to remove it from the S&P 500 index, something which is not possible in a mutual fund or ETF.

At the Inside ETFs conference, Hougan commented: “Dave and I want to welcome you to the next phase of the asset management industry, what we’re calling ‘the great unwrapping’, where your process of getting from wanting securities to owning securities doesn’t have anything in between – doesn’t have a fund structure.”

The report said this type of investing was not possible until recently due to high brokerage costs and "arcane" portfolio accounting systems.

John West, head of client strategies and marketing at Research Affiliates, and co-author of the report, added: “That being said, over the last few years dramatic technological advances have improved the robustness, speed, and capacity of systems and lowered the asset levels necessary to make direct indexing accessible to investors.”

Positive tax alpha, West said, was far easier to achieve with direct indexing than with a wrapped vehicle as investors could choose when selling holdings.

“Realised losses in one portfolio can increase after-tax returns by offsetting capital gains in the client’s other investment portfolios.”

Added to improving an investor’s tax situation, smart beta direct indexing also enables them to implement specific beliefs such as environmental, social and governance (ESG) preferences that are not already factored into existing ESG indices.

This is a major advantage of direct indexing as investors are increasingly aligning their investing beliefs with personal values.

For example, research found that Morningstar’s Sustainability Rating caused highly rated funds to see $24bn positive flows in the 11 months after they were launched while low rated funds saw over $12bn outflows.

“A client’s socially responsible preferences influence the approach the adviser implements—a stronger or more distinctive preference requires a greater level of customization.

West said: “As direct indexing becomes increasingly available to investors given rapid advances in technology, advisers are uniquely positioned to assess whether this opportunity fits into their clients’ portfolios, and if so, to maximize its potential.

A careful consideration of smart beta direct indexing needs to be near the top of an adviser’s to-do list in the years ahead.”

However, the report also highlighted a number of potential obstacles to widespread smart beta direct indexing.

Despite rapid technological changes, the report said trading numerous securities in a portfolio is more complex and cumbersome than investing in a wrapped product.

This greater operational complexity firms would experience could increase and exacerbate errors.

Furthermore, not every investor is in need of the tax advantages smart beta direct indexing offers.

“Such benefits are muted, however, if a client’s portfolio is expected to generate limited taxable gains and, of course, are irrelevant in a tax-deferred account such as an IRA.

“Wrapped products remain an important part of the adviser’s toolkit,” the report continued. “Indeed, we view smart beta direct indexing as a complement to smart beta ETFs and mutual funds.”