Skip to main content

The benefit of direct indexing for sustainable investing strategies is that many ESG-themed ETFs or mutual funds may not accurately reflect an investor’s values.Kanizphoto/iStockPhoto / Getty Images

Sign up for the new Globe Advisor weekly newsletter for professional financial advisors on our newsletter sign-up page. Get exclusive investment industry news and insights, the week’s top headlines, and what you and your clients need to know.

Direct indexing is taking off in the United States driven by a growing desire for customized, tax-efficient portfolios and the rise in fractional shares and zero-commission trading, but advisors in Canada aren’t likely to have any meaningful participation for years to come.

“I’m not holding my breath; it probably isn’t going to happen for the masses here anytime soon,” says Jason Pereira, partner and senior financial consultant at Woodgate Financial Inc., a financial planning firm under the IPC Securities Corp. umbrella in Toronto.

Direct indexing – which is the practice of buying the individual stocks that make up an index instead of a mutual fund or exchange-traded fund (ETF) – is expected to grow at an annualized rate of more than 12 per cent in the U.S. by 2026, according to a report released last year by Cerulli Associates.

The report says that rate is expected to be faster than growth of traditional financial products such as ETFs (11.3 per cent), mutual funds (3.3 per cent) and separate accounts (9.6 per cent). Overall, direct indexing assets accounted for nearly one-fifth of the U.S. industry’s total retail separate account assets in 2020, totaling US$362-billion.

And while considered a niche product used by a small group of advisors for high-net-worth clients, Cerulli says industry momentum is building and the market is expanding as a growing number of asset managers in the U.S. acquire direct indexing providers to broaden their service offering.

Tom O’Shea, research director for managed accounts at Cerulli in Boston, says direct indexing has been around for decades, but there were cost and structural constraints that meant it was used largely by large institutional investors or only very affluent individual investors.

As trading technology has advanced and costs have come down, direct indexing has become more accessible. The advantages are more customized portfolios that are tax-efficient, largely through the ability to harvest gains and losses by individual securities.

One major use for direct indexing is investors looking to select stocks through an environmental, social, and governance (ESG) lens. Given the values and definitions of ESG investing vary greatly – for instance, some investors refuse to put money in fossil fuel names while others choose only those with active carbon reduction strategies – direct indexing enables more customization.

It provides “a new opportunity for wealth managers to offset fee erosion and provide clients a differentiated offering,” according to a recent report from Deloitte Canada.

While there is no large player in the ecosystem today, according to Deloitte, “the first incumbent player to market with the offering will benefit from a significant first-mover advantage.”

Tax break in the U.S. vs. Canada

Canadian advisors would welcome the growth of direct indexing in this country, but the tax benefits aren’t as valuable as they are in the U.S., notes Mr. Pereira.

The U.S. taxes short- and long-term capital gains differently. Short-term capital gains on securities owned for less than a year in the U.S. are taxed as ordinary income, while long-term gains owned for more than a year are taxed at “preferential rates,” he says of zero, 15 or 20 per cent. In Canada, capital gains on securities are taxed the same, regardless of how long the investment was held.

“That’s not to say that tax-loss harvesting is invaluable in Canada; it’s just more impactful in the U.S.,” he adds.

The “big play” for direct indexing is ESG investing, Mr. Pereira says, calling it the “future of ESG.” He cites the example of investors who might want to exclude companies that sell guns or tobacco from their portfolios.

“It allows for the degree of minute of detail overlay into ESG,” he says. “While ESG managers screen out companies based on scoring or criteria, this will allow the individual to have that same purview of discretion, but to their personal values.”

The cost of direct indexing

Still, he argues there’s no cost-benefit for advisors to do this kind of customization.

“Even the direct indexing companies doing this in the U.S. cost more than the equivalent ETF,” Mr. Pereira points out, because of the cost of trading.

That expense issue explains in part why direct indexing hasn’t taken off in Canada.

“It’s logistically feasible for a very large portfolio – a pension fund can do this no problem – but it’s difficult for smaller accounts,” he says. “Most of the custodians, to the best of my knowledge, can’t support this at this point. To do it, their economic business model would have to change drastically.”

Even if direct indexing becomes common in Canada, it’s likely to remain more expensive than traditional indexing that comes with most low-cost ETFs, says Dan Bortolotti, portfolio manager and certified financial planner at PWL Capital Inc. in Toronto.

Mr. Bortolotti also doesn’t see direct indexing as offering the efficiency or convenience many advisors and investors seek.

“Direct indexing is probably an easy way to build and maintain a well-diversified portfolio, but simply buying a broad-market ETF is even easier,” says Mr. Bortolotti, author of the recent book, Reboot Your Portfolio: 9 Steps to Successful Investing with ETFs.

And while customization is a benefit of direct indexing, he’s not sure tweaking an index by adding or deleting individual companies, or changing sector weights will add value.

“It’s just a specific type of active management,” he says. “It would be hard to make the case that customization is likely to enhance returns.”

How customization can work

Still, Mr. Bortolotti sees the benefit of direct indexing for sustainable investing strategies since many ESG-themed ETFs or mutual funds may not accurately reflect an investor’s values. He uses an example of some ESG indexes removing so-called “sin” stocks, which are companies in industries such as alcohol, gambling, and firearms. He notes that some investors might be okay with alcohol companies but not gun manufacturers.

“With an off-the-shelf ETF, you have no flexibility, whereas, with a direct indexing strategy, you can create a portfolio that more accurately represents your values and priorities,” he says.

As for the tax-loss selling benefits with direct indexing, Mr. Bortolotti argues that most broad-market ETFs are very well-managed from a tax perspective.

“It’s not uncommon for them to go many years without distributing capital gains to their unitholders,” he says, adding that many broad-market ETFs also make it “extremely useful to harvest losses in taxable accounts” – something his firm often does for clients.

For more from Globe Advisor, visit our homepage.