Will direct indexing revolutionise investing?

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By nature, humans love to customise things.

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

An interaction with a device, person, or thing that is personal and customised leaves us feeling like our needs and interests are being considered, like we have a little more control.

direct indexing revolution

However, in the world of financial services, investors don't often receive that same bespoke treatment.

Until now, that is. Enter, direct indexing.

In its simplest form, direct indexing involves directly investing in the actual securities that make up an index.

This approach is dissimilar from investing in exchange-traded funds (ETFs), which track an index or mutual funds that follow a benchmark index.

Direct indexing allows investors to own the securities that make up an index and hold them in a separately managed account (SMA).

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

The concept has gained traction in the United States in recent years, with total assets under management in 2020 sitting at around US$350 billion. According to a 2021 report from Oliver Wyman and Morgan Stanley, this could grow to about US$1.5 trillion by 2025, drawing flows that would otherwise be snapped up by ETFs or mutual funds.

To explain direct indexing further, Vanguard senior investment strategist Inna Zorina uses the analogy of going to the gym.

"Normally, there are quite a wide range of classes at these gyms, so members can walk in and select some classes off the shelf that would suit their needs," Zorina explains.

"But occasionally, there may be a need for some personal treatment, for example, a member may be preparing for a competition, or they may be dealing with an injury, or they just want a personal approach to their workout, and in this case, they will use a coach.

"That coach would work with them to create a tailored product to suit their needs, and to help them to meet their goal efficiently and effectively.

"It's quite similar when we look at the direct indexing and ETFs and mutual funds. We have a wide line-up of ETFs and mutual funds, and they would suit the needs of majority of investors out there. But some investors may need more customisation and this is the niche that will be occupied by direct indexing."

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

Hot on their trail, Vanguard acquired Just Invest, a direct indexing company, in October last year. Then, in December 2021 BNY Mellon's Pershing acquired Optimal Asset Management, the business of which is solely in direct indexing.

Already in 2022, Fidelity, which administers US$11.5 trillion in assets, filed documents with regulators to launch what appears to be the first direct-indexing product for retail investors. Fidelity Managed FidFolios, which should be available before the end of March, will be accessible to individual investors with as little as $5000, Fidelity says.

One major factor driving the growth of direct indexing in the US is its newfound accessibility to investors.

"Traditionally, direct indexing has only been available to those who could afford it (in other words, the ultra-rich).

However, two things have broadened the market for this strategy: the rise of commission- free trading and fractional share stock investing. Meanwhile, asset managers are responding to this momentum by acquiring direct indexing providers, introducing their own proprietary solutions, and applying direct indexing to new asset classes.

While direct indexing is yet to reach the shores of Australia, BetaShares chief commercial officer Ilan Israelstam says there are many benefits to the approach.

"In a world where we have the right technology and ability to access direct indexing, which at the moment, quite frankly, isn't in Australia, it could mean that we could create a product or an investment that meets a customer's specific needs, rather than something that's been put out there by a fund manager like ourselves," he says.

Israelstam notes the best example of this is ethical investing, because it makes the most sense for those who want to use direct indexing.

"When it comes to ETFs, the vast majority of investors will go ahead and buy an ethical ETF that they've researched carefully and have worked out meets their ethical standards," he says.

"That gives them what they're looking for - they've invested in a simple way, and it gives them the kind of exposure they want."

However, he says, this may not work for some- one with a very particular idea of what ethical investing means.

"For example, if that somebody was a vegan, there could be an ethical ETF that took out everything they liked except for a few companies in there that were non-vegan," Israelstam says.

"If they used a direct indexing approach, they could create their own index and remove the companies that confront their vegan sensibilities and get exposure in exactly the way they want."

Zorina agrees that applying an ESG screen is a major benefit of the direct indexing method.

"Sometimes a client may want ESG products to invest in line with their values, but they may struggle to find a particular product that meets all the criteria, and in this case, they may want to consider direct indexing," she says.

Zorina added that other benefit of direct indexing includes tax optimisation or increasing or decreasing an investor's exposure to certain- securities.

"Sometimes, investors may have existing positioning in fund securities, or exposure to a particular company, and they may not want to double that load," she explains.

"Direct indexing can help them to tailor their portfolio around these so they may exclude a particular security again, to suit their personal needs."

Benefits aside, there are also trade-offs to the direct indexing approach: complexity and cost being the main culprits.

VanEck chief executive and managing director Arian Neiron says a major hurdle of direct indexing is that it's "not as straightforward as following an index".

"Direct indexing is complex, as there are so many mechanical movements and cogs in the wheel that goes into that index construction every day," Neiron says.

"Corporate actions are a significant part of this. You've got to have the expertise, re- sources, and technology to be able to provide the service."

"Unfortunately, it isn't available in Australia yet within the regulatory framework - it's a fiduciary responsibility."

Talking time frames, Neiron predicts it'll be at least a decade before Australia starts to see technology and major adoption of direct indexing.

"I really can't see it happening in the short term, but it's a possibility, as investors do grow their wealth," he says.

"Currently, the ETF market is within the product proliferation of innovation, and that's going to be a natural challenge for direct indexing, because the pace of innovation and ETF production is faster than the ability of direct indexing and customisation."

In other words, when direct indexing does enter Australia, it is unlikely to disrupt the $10 trillion-dollar industry of ETFs.

A self-confessed sneaker fanatic, Neiron likens direct indexing to purchasing a pair of customised Nikes.

"When it comes to shoes, are every pair of Nikes customised? No. "You might try to create your own, but at the end of the day, at least in my case, you think: 'I'm not that creative! I'll leave it to Nike to design the sneakers for me'," he says.

"In a similar way, when you're buying that IP in an ETF, you're buying that professional management.

"You've got to be very self-aware and have that expertise."

And while technology can certainly make direct indexing more accessible, Neiron is doubtful that it will disrupt the ETF market.

"It's analogous to the shoes," Neiron says.

"I don't know about your cupboard, but mine only has one pair of customised Nikes, and I hardly wear them."

While still arguably a long way off, direct indexing is an exciting development, and one that large institutions and smaller providers alike are readying for.

"Like every provider who's deep in the investing and ETF space, we're definitely having a careful look at direct indexing," Israelstam says.

"We want to make sure if it's done, it is done with a lot of care and consideration and isn't just done to reach something that's topical and faddish.

"Most importantly, we want to make sure it really adds value to investors and their advisers."

Much like a Spotify playlist, direct indexing allows investors to mix up their own fund with a greater degree of customisation and control.

Of course, this strategy isn't for everyone.

To critics, direct indexing is an attempt to rebrand active investing or SMAs, just to extract higher fees than most ETFs charge. For others, it may be exactly the solution they've been looking for.

After all, in the words of Spotify founder Daniel Ek: "Who doesn't love a personalised 'for you' approach?"

This article first appeared on Financial Standard

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Chloe Walker is a journalist at Financial Standard. She has a Bachelor's degree in journalism from QUT.

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