Direct Indexing has been around for decades, but many investors are just hearing about it now. Rather than buy a single fund such as an ETF or mutual fund, Direct Indexing allows the investor to replicate the performance of an index by purchasing the underlying shares or use an index as the starting universe for a custom portfolio. The strategy allows for greater personalization to the investor and it has recently attracted some buzzworthy attention.
As the Direct Indexing buzz has escalated, assets in the approach have been growing rapidly. Looking ahead, they are expected to continue on this trajectory, outpacing both ETF and mutual fund growth over the next five years. Another estimate projects that direct indexing could grow from $350BN AUM in 2020 to $$1.5TN by 2025.
We have identified three reasons why there has been a recent surge in Direct Indexing popularity—and why many investors haven’t heard of this decades-old strategy until now.
Reason #1: It’s no longer just for ultra high net worth investors
When the first Direct Indexing portfolio was designed three decades ago, costs for this custom-built index-based portfolio strategy were prohibitive for everyone but the highest net worth investors. Buying the underlying shares of an index with hundreds—or even thousands—of constituents would result in costly trading commissions or incremental tax burdens when selling positions. Buying full shares of each of these stocks would allow for the necessary diversification, but by nature require a large minimum investment and manual tracking of constituents and weights on an ongoing basis all at a higher management fee.
However, three key trends have since removed these barriers and considerably reduced investment minimums for Direct Indexing. One, fractional-share trading has entered the mainstream, enabling investors to buy pieces of high-priced stocks. Two, many asset managers now have technology platforms to launch index SMAs with the ability to manage for tax-efficiency through algorithms. Three, financial advisors now have the ability to track positions not just at the security level but down to the tax lot / cost basis level, enabling them to cherry pick the optimal positions that meet the investor’s stated goals.
Reason #2: Did someone say tax efficient harvesting?
In recent years we have seen a paradigm shift in how investors are thinking about their portfolio objectives. They are no longer focused solely on performance and instead are setting more holistic goals driven by their individual needs. One such objective is tax efficiency, which has become a top priority for investors concerned about their tax bills eroding portfolio returns. By design, Direct indexing allows for a higher degree of customization than ETFs or mutual funds. And holding individual securities directly facilitates tax harvesting on an individual index constituent level, thereby offering the potential to offset other income that investors file on their annual tax return—a feature not available in an ETF or mutual fund.
Tax efficiency needs are not just met through selling losses. Many high net worth investors are also focused on donations to 501c-3 organizations that meet their personal beliefs. In some instances, large unrestricted concentrated stock positions or positions that have had significant gains could be donated to achieve tax efficiency goals.
As shown, there are many similarities between passive mutual funds, ETFs, and Direct Indexing. But a key difference is the ability to tax loss harvest that comes with Direct Indexing, which has the potential to deliver tax alpha opportunities.
What's the difference?
|Investor Benefit||Passive Mutual Funds||ETFs||Direct Indexing|
|Seeks to track the performance of market index||Yes||Yes||Yes|
|Full index constituent replication||Yes||Yes||Yes|
|Low relative fees||Yes||Yes||Yes|
|Tax efficiency||No (subject to capital gains tax)||Yes - typically do not pay out capital gains tax||Yes - opportunity to implement a tax management strategy|
|Tax loss pass through||No - mutual funds cannot pay out realized lossess to investors||No - ETFs cannot pay out out realized losses to investors||Yes - potential to create tax alpha through tax loss harvesting|
|Ability to tax loss harvest||No||No Only down market||Potential in all markets|
|Ability to customize the individual portfolio||No||No||Yes - can tilt toward sectors or ESG factors, or exclude certain areas|
Source: FTSE Russell. For informational purposes only. Nothing contained in this presentation or stated today is intended to constitute tax or investment advice, nor an opinion regarding the appropriateness of making any investment through indexes. Please see the end for important disclosures.
Reason #3: More investors want ESG their way
Tax efficiency isn’t the only portfolio objective that requires a bespoke solution. More investors than ever care about incorporating ESG considerations in their portfolios—and what matters to one investor might not be as important to the next. The rise of ESG investing and its inherent subjectivity means that index investors are now placing a greater value on customization.
With lower account minimums, Direct Indexing can now offer more investors the ability to customize index allocations to meet their individual ESG requirements—a type of strategy that was once only available to large institutional investors.
Is the Direct Indexing buzz only just beginning?
Despite decades of history, Direct Indexing is only just now rising to prominence in the index investing conversation. Lower account minimums and growing investor demand for portfolio customization have recently propelled it into the mainstream—generating growth that some expect will continue into the foreseeable future.
When considering an index for Direct Indexing, it will be increasingly more important that financial intermediaries and investors understand the nuances of the underlying index. Those nuances include, but are not limited to, working with a trusted brand, understanding the index methodology and how constituents and weights may change over time, and the ability to gain/reduce exposure to IPOs and other securities while maintaining a risk-managed approach to portfolio construction that meets the investor needs.
At FTSE Russell, we are focused on delivering the highest quality data and indexes to our clients and are agnostic as to the indexing approach they take. As the index investing landscape has evolved to accommodate investment allocations of all sizes, it has grown to include mutual funds, ETFs, and now Direct Indexing. The result of this evolution is more choice in how investors approach passive investing—and an enhanced ability to meet their unique needs.
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