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Will direct indexing revolutionize investment?

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By nature, people like to set things up.

From personalized recommendations on Netflix and Stan to suggested playlists on Spotify or iTunes, everyone wants to have things that serve them by knowing them.

Interacting with a device, person, or thing that is personal and customized makes us feel that our needs and interests are being taken into account as if we have a little more control.

However, in the world of financial services investors do not often receive the same individual treatment.

So far it means. Enter, direct indexing.

In its simplest form, direct indexation involves investing directly in the real securities that make up the index.

This approach is different from investing in exchange-traded funds (ETFs) that track the index or mutual funds that follow the benchmark index.

Direct indexation allows investors to own the securities that make up the index and keep them in a separate managed account (SMA).

For example, if replicating the S & P500, the investor will directly own all the stocks in the index.

In recent years, the concept has gained popularity in the United States, and total assets under management in 2020 will be about $ 350 billion. According to a report by Oliver Wyman and Morgan Stanley for 2021, by 2025 this could grow to about $ 1.5 trillion, attracting flows that would otherwise have been seized by ETFs or mutual funds.

To further explain direct indexing, Vanguard senior investment strategist Ina Zorina uses an analogy with going to the gym.

“Usually in these gyms there is a wide range of classes, so participants can go and choose from the shelf classes that meet their needs,” – says Zorina.

“But sometimes there may be a need for some personal attitude, for example, a participant may be preparing for a competition, or he may be dealing with an injury, or just want a personal approach to training, and in that case, they will use a coach.

“This coach will work with them to create a product that meets their needs and help them achieve their goal effectively and efficiently.

“It’s very similar when we look at direct indexation, ETFs and mutual funds. We have a wide range of ETFs and mutual funds and they meet the needs of most investors. But some investors may need to adjust more and this is the niche that direct indexation will occupy. ».

Already in the US, direct indexing is offered by companies such as Vanguard, Morgan Stanley, BlackRock and JPMorgan Chase. In late 2020, Morgan Stanley acquired asset manager Eaton Vance primarily for its subsidiary direct indexing company Parametric, and BlackRock acquired Aperio, a leading provider of personalized index capital solutions.

Last October, Vanguard acquired Just Invest, a direct indexing company. Then in December 2021 Pershing of BNY Mellon acquired Optimal Asset Management, whose business is exclusively direct indexing.

As early as 2022, Fidelity, which manages assets worth $ 11.5 trillion, has filed for the regulator to launch what appears to be the first direct-indexed product for retail investors. Fidelity Managed FidFolios, which should be available by the end of March, will be available to individual investors for just $ 5,000, Fidelity says.

One of the main factors in the growth of direct indexation in the US is its new availability to investors.

“Traditionally, direct indexing was only available to those who could afford it (in other words, the super-rich).

However, two things have expanded the market for this strategy: growth in commission-free trading and small-scale equity investment. Meanwhile, asset managers respond to this impulse by acquiring direct indexing providers, presenting their own patented solutions, and applying direct indexing to new asset classes.

While direct indexation has not yet reached the shores of Australia, BetaShares commercial director Ilan Israelstam says the approach has many benefits.

“In a world where we have the right technology and the ability to access direct indexing, which is currently, frankly, not available in Australia, it could mean we can create a product or investment that meets the specific needs of the client, rather than that was stated by the head of the fund, like us, ”he says.

Israelstam notes that the best example of this is ethical investing, because it is most reasonable for those who want to use direct indexation.

“When it comes to ETFs, the vast majority of investors buy an ethical ETF that they have researched carefully and that meets their ethical standards,” he says.

“It gives them what they’re looking for – they’ve invested in an easy way, and it gives them what they want.”

However, he says, this may not work for someone with a very specific idea of ​​what ethical investing means.

“For example, if that person was a vegan, there might be an ethical ETF that took everything they liked, except for a few companies that weren’t vegans,” he told Israel.

“If they used a direct indexing approach, they could create their own index and remove companies that oppose their vegan sensitivity, and access exactly the way they want.”

Zorina agrees that the use of ESG screen is the main advantage of the direct indexing method.

“Sometimes a customer may want ESG products to invest in line with their values, but it may be difficult for them to find a specific product that meets all the criteria, and in this case they may want to consider direct indexing,” she says.

Zorina added that other benefits of direct indexation are the optimization of taxation or increase or decrease of investor risk to certain securities.

“Sometimes investors may have existing positions in the fund’s securities or risks for a particular company, and they may not want to double that burden,” she explains.

“Direct indexing can help them tailor their portfolio to them so they can re-exclude a particular security to meet their personal needs.”

In addition to the advantages, there are trade-offs with the approach to direct indexing: complexity and cost are the main culprits.

VanEck CEO Arian Neyran says the main hurdle to direct indexing is that it is “not as simple as indexing”.

“Direct indexing is difficult because there are so many mechanical movements and cogs in the circle that are included in this index design every day,” says Neyran.

“Corporate action is a big part of that. You have to have the experience, resources and technology to be able to provide services. ”

“Unfortunately, in Australia it is not yet available within the regulatory framework – it is a fiduciary responsibility.”

Speaking of timeframes, Neiron predicts it will take at least ten years before Australia begins to see technology and widespread adoption of direct indexing.

“I really can’t see it happening in the short term, but it’s possible as investors increase their wealth,” he says.

“Currently, the ETF market is within the reach of innovation, and this will be a natural challenge for direct indexing because the pace of innovation and ETF production is higher than the ability for direct indexing and customization.”

In other words, if direct indexation is indeed coming to Australia, it is unlikely to disrupt the $ 10 trillion ETF industry.

A recognized fan of sneakers, Neiron compares direct indexing to the acquisition of a pair of individual Nike.

“When it comes to shoes, is every Nike pair custom-made? No.” You can try to create your own, but in the end, at least in my case, you think, “I’m not that creative! I’ll leave this Nike to design sneakers for me, ”he says.

“Similarly, when you buy this IP in an ETF, you buy this professional management.

“You have to be very self-aware and have that experience.”

And while technology can certainly make direct indexing more affordable, Neiron doubts it will disrupt the ETF market.

“It’s the analog of shoes,” Neyran says.

“I don’t know how your closet is, but mine only have one pair of individual Nike, and I hardly wear them.”

Although perhaps still a long way off, direct indexing is an exciting event for both large institutions and small providers.

“Like any vendor that is deeply involved in investing and ETFs, we are definitely looking closely at direct indexation,” Israelist says.

“We want to make sure that this is done with great care and attention, and not just to achieve something relevant and bizarre.

“Most importantly, we want to make sure it really adds value to investors and their advisors.”

Like Spotify’s playlist, direct indexing allows investors to mix their own fund with more customization and control.

Of course, this strategy is not for everyone.

For critics, direct indexation is an attempt to rebrand active investing or SMA, simply to get higher fees than most ETFs charge. For others, it may be exactly the solution they were looking for.

In the end, in the words of Spotify founder Daniel Eco: “Who doesn’t love a personal approach” for you “?”

This article first appeared on the Financial Standard

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https://www.moneymag.com.au/direct-indexing-revolution

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