Direct indexing emerges as must-have tool for tax management, ESG investing

The trend toward offering customizable indexes puts direct indexing on a track for explosive growth, according to new research from Cerulli Associates.


Jeff Benjamin

If you’re a financial adviser who is not yet familiar with the concept of direct indexing, you are dangerously close to falling behind the curve.

Seemingly from out of nowhere, and riding on a wave of zero-cost trading platforms, the advent of fractional shares and new technology that brings it all together, the idea of customized indexing has become one of the hottest topics in wealth management.

Even though the potential market is mostly limited to tax management for wealthy investors and those passionate about ESG investing, Cerulli Associates is predicting that the growth will outpace that of mutual funds, ETFs and separately managed accounts over the next five years.

Direct indexing is basically the next level of separately management accounts because it leverages emerging technologies to customize just about any index to meet an investor’s specific needs, whether it is for tax management, ESG preferences or even to navigate around over-weighted exposure to specific stocks.

Cerulli director Tom O’Shea said the recent popularity is a sign of more growth to come as the largest financial services conglomerates like “Vanguard, BlackRock and Schwab start to embed the technologies they’ve been purchasing.”

“You’re going to see a situation where an adviser has a console and inputs client preferences related to taxes, ESG, or factor tilts, and the client ends up with a portfolio of individual securities managed according to these preferences in a kind of mass customization,” he said.

O’Shea’s research shows that direct indexing currently represents about 22% of the separately managed accounts industry’s total assets, and that the growth potential is explosive.

According to the research, managed account sponsors rank tax management as a leading opportunity to use direct indexing, followed by ESG customization, factor investing and thematic portfolio construction.

Cerulli’s calculations show direct indexing currently represents more than $362 billion, but the projected five-year growth rate is 12.4%, ahead of ETFs at 11.3%, SMAs at 9.6%, and mutual funds at 3.3%.

“Our findings suggests that direct indexing will help wealth managers achieve a more robust service offering, fulfilling unique portfolio customization requirements from investors across the wealth spectrum,” O’Shea said.

Leon LaBrecque, chief growth officer at Sequoia Financial Group, said he uses the strategy to create “tax alpha” and that about 6% of his clients’ assets are allocated into direct-indexing portfolios.

“We’re seeing ways to quantify the tax alpha, and that’s pretty compelling,” he said. “The more volatile the index is, the more alpha can be captured.”

LaBrecque is still primarily using direct indexing for wealthier clients in taxable accounts, but he is also seeing interest among some clients to try it for ESG preferences.

LaBrecque employs direct-indexing portfolios through Parametric, which is a pioneer and leader in the space. But the list of firms offering the strategy is vast and growing.

“More and more investors and their advisers are recognizing the value — the tax advantages, the flexibility, the ability to tailor to client mandates — that these SMAs offer,” said Brian Langstraat, Parametric chief executive officer.

Shane Morrow, managing partner at IronBridge Wealth Counsel, uses direct indexing strategies for both tax management purposes and for custom model exposure to broad asset classes.

“Direct indexing is a significant technological tool for advisers to hyper customize their portfolios to the specific needs of their clients whether it is for taxes, security avoidance, expressing investment preferences, or factor exposure tilts,” he said.

From Morrow’s perspective, the appeal is “the ability for advisers to uniquely customize an investment solution but still leveraging the institutional properties of indexing and asset-allocation modeling.”

Nate Geraci, president of The ETF Store, is well versed in the rapid evolution of direct indexing and he agrees that the tumblers are lined up for a growth spurt. But he also sees the potential market as still somewhat limited, considering that the vast majority of investor assets are held in qualified retirement accounts that would not benefit for tax management strategies.

“The use cases for direct indexing are fairly limited, mostly to the higher-net-worth with assets in taxable accounts and high-conviction ESG investors,” he said.

Geraci also points out the irony of going against the grain of the three biggest trends in asset management over the past decade, including movements toward passive investing, lower costs and simplicity.

“Ultimately, direct indexing is active management, and it’s higher cost,” he said, citing issues that have sometimes made direct indexing a “polarizing topic.”

But even while acknowledging what could be viewed as short comings, Geraci said financial advisers should become familiar with direct indexing.

“The appeal of direct indexing is growing and it is something advisers should likely have as a tool in their tool box,” he said.


Latest Stories