Direct indexing, the next phase of portfolio customization, is gaining traction among some financial advisors and their high-net-worth clients.
Although traditional index-tracking mutual funds or exchange-traded funds (ETFs) allow investors to buy all stocks in an index at once, direct indexing enables mass customization through the purchase of individual stocks. It’s appealing for investors looking to own an index, but not certain stocks in it.
An example is an investor in Calgary working in the energy industry who may want to underweight the sector in her broader investment portfolio. Direct indexing is also a good choice for responsible investors who want to buy an index but may wish to remove companies with poor social or environmental records.
“You can tailor the index to your situation,” says Mary Hagerman, a portfolio manager and advisor at Desjardins Wealth Management Securities in Montreal, who likens direct indexing to buying a custom-made suit instead of one off the rack. “It’s taking people back to the beginning of the process and saying, ‘before we chop it up into little bites … you can do what you want with the pieces.’”
With customization often comes extra costs – and direct indexing is no different. However, direct indexing enables investors to take advantage of tax-loss harvesting in a way they can’t with mutual funds or ETFs, which can offset the additional costs.
Direct indexing is more complicated than individual stock-picking and requires time and significant assets, which is why investors often seek the help of advisors.
“This isn’t going to be for every investor … but people are looking for these solutions,” says Ms. Hagerman. “Anything we can do for clients to get them a better after-tax return helps to set us apart.”
Institutional investors have been using direct indexing for decades but it was considered out of reach for even most high-net-worth investors because of the high fees involved. The cost has come down in recent years amid lower management fees across the industry as well as rebalancing automation technology and fractional-share selling, which has made trading more efficient.
“The technical hurdles have now been overcome,” says Matthew Hougan, global head of research at Bitwise Asset Management Inc. in San Francisco and chairman of Inside ETFs, the world’s largest ETF conference. He touted the benefits of direct indexing at this year’s conference in Hollywood, Fla., in February.
Although Mr. Hougan says he’s never been more bullish on the growth of ETFs, he sees direct indexing as a “new technologically enabled solution that is better in certain situations for certain types of investors.”
Mr. Hougan described direct indexing during the event as an “intelligent replication of broad market indexes” that uses the same process that passive ETFs use, but with a separate, customized portfolio for each client.
He notes that institutions and ultra-high-net-worth families have been using this strategy for years because of the transparency it provides, the direct ownership of each security and its tax efficiency. Mr. Hougan cited statistics showing the tax-loss harvesting has provided a 1- to 2-per-cent annual after-tax return benefit. What’s more, he says, direct indexing is easily adapted to concentrated positions and market views.
For example, he points to environmental, social and governance (ESG) investing, which he says investors have struggled with for years.
“Nobody cares about ESG [in the general term],” says Mr. Hougan, who is also global head of research for Bitwise Asset Management. “What we care about are things like gun rights, global warming or any of a variety of individual things. Direct indexing lets you screen out, or screen in, exactly the thing you care about instead of forcing a one-size-fits-all [approach]. It’s the only solution that brings ESG to the masses … It solves the ESG problem.”
Apart from the customization and tax advantages, Mr. Hougan also believes direct indexing will help solve what he calls “the investor gap, by making investors more attached to their individual portfolios.”
Warren Collier, managing director and global head of index strategy at BlackRock Inc., the firm behind the iShares ETF family, sees direct indexing as a complement to traditional investment funds.
“There is a set of clients for whom it does add value and we see it as complementary to our core business,” he says. “We are constantly looking at ways of taking the simple thesis that index investing ... is good and finding the best ways of delivering it.”
Although direct indexing is used predominantly by high-net-worth investors for tax-management purposes, Mr. Collier says, the approach also helps investors tailor their portfolios to address specific needs. Still, he says it works best when a portfolio is large enough that the tax benefits outweigh the cost of trading multiple securities.
“It’s a relatively small portion of investors,” Mr. Collier says, “but there’s definitely a market there and more room for it to grow in Canada.”