introduction
Direct indexing is the order of the day. In October 2020, Morgan Stanley bought the asset manager Eaton Vance primarily due to its direct index subsidiary Parametric. BlackRock followed suit a month later with the acquisition of Aperiothe second largest player on this area. This yr JPMorgan bought OpenInvest in June, Vanguard acquired its partner JustInvest in Julyand in September, Franklin Templeton acquired O’Shaughnessy Asset Management (OSAM) and its direct indexing platform Canvas.
The giants of the asset management industry are clearly fascinated by direct indexing, and it isn’t hard to see why. The rise of exchange-traded funds (ETFs) has seen the management fees of mutual funds and ETFs themselves fall steadily, and with greater than 2,000 U.S. ETFs and 5,000 U.S. equity funds, all based on a universe of just 3,000 stocks, that is little room for extra products. The industry is in search of latest revenue-generating business lines, and growing client interest in customized portfolios has not gone unnoticed.
For Wall Street’s marketing machines, direct indexing needs to be easy: a portfolio could be fully customized to a client’s preferences, for instance by excluding all stocks that contribute to global warming or prioritizing high-quality domestic stocks. Tax-loss harvesting can be offered. And all in a reasonably automated way using modern technology stacks at low price.
Like many investment proposals, direct indexing looks like a free lunch that is too good to pass on. But is it?
An overview of direct indexing
Although firms like Parametric have been offering direct indexing to their clients for many years, the market’s assets under management really began to grow in 2015. Over the past five years, direct indexing assets under management increased from $100 billion to $350 billion. This is partly since the technology to create software became cheaper and easier to make use of, opening the market to latest entrants. The rise was also driven by Millennials in search of personalized portfolios, often with a concentrate on environmental, social and governance (ESG) considerations.
Assets under management (AUM) in direct indexing, US billions
How strong is the dynamic in the world of ​​direct indexing? A market research study by Cerulli Associates in the primary quarter of 2021 predicted higher AUM growth in direct indexing than ETFs, separate managed accounts (SMAs) and mutual funds over the following five years.
Of course, a cynic might argue that direct indexing is little greater than an SMA in a contemporary technology stack. That could also be a legitimate point, however it’s a discussion for an additional day.
Projected five-year AUM growth rates by product as of Q1 2021
The dark side of direct indexing
Direct indexing marketing materials emphasize that every customer receives a totally customized portfolio. The copy could describe a novel, customized, or bespoke portfolio: Starbucks’ tall, iced, sugar-free vanilla latte with soy milk versus Dunkin’ Donuts’ traditional coffee.
What speaks against being treated like a wealthy UBS customer? Everyone deserves a private portfolio!
However, this offering ignores one thing. What is definitely being sold here is pure energetic management. A client who excludes or underweights certain stocks that he considers undesirable from the universe of a benchmark index comparable to the S&P 500 is doing exactly what every US large-cap fund manager does.
But a client who builds his own portfolio based on personal preferences, even when a financial advisor manages the direct indexing software, is unlikely to be any higher at stock selection or portfolio construction than a full-time fund manager from Goldman Sachs or JPMorgan Asset Management.
Worse, most skilled money managers underperform their benchmarks in each the short and long run, whether or not they put money into U.S. or emerging markets, small caps or area of interest stocks. Fees for direct index portfolios are typically lower than for equity funds, giving them an edge, but investments based on personal selections are unlikely to outperform those of already poorly performing fund managers.
Customers with direct indexing should due to this fact not expect to have the opportunity to maintain up with the market.
Equity fund managers underperform their benchmarks
The Risks of Tax Loss Harvesting
Even if their portfolios underperform, direct index investors still have access to a different vital feature: tax-loss harvesting.
Here, stocks are sold at a loss as capital gains from profitable transactions are realized, thereby reducing the web tax liability. In practice, shares sold can’t be repurchased until 30 days after the sale, meaning an investor must buy something else as an alternative.
There are various arguments that the tax profit is way smaller in practice than in theory. Some even claim that liability is merely postponed moderately than reduced.
Regardless, managing an investment portfolio based on tax decisions is fundamentally flawed and carries significant risks, comparable to selling losing stocks at an inopportune time, comparable to during a stock market crash. Typically, the worst-performing stocks rebound essentially the most during recoveries, so in the event that they were sold, the investor receives all the losses but only a portion of the gains. In addition, replacing losing stocks with other positions changes the portfolio’s risk profile and factor exposure.
However, essentially the most critical argument against tax loss harvesting is that, like direct indexing, it is solely a more energetic type of administration. Hendrik Bessembinder showed that since 1926, just 4% of all stocks have accounted for nearly all the excess returns over short-term U.S. Treasury bonds. Most stock market returns come from a handful of firms, comparable to the FAANG stocks in recent times. Not investing in any of those firms to be able to maximize tax advantages, for instance, is solely too dangerous a call for many investors.
Shareholder wealth creation beyond one-month U.S. Treasury bonds, 1926 to 2016, trillion dollars
More thoughts
Investors have recognized that energetic management is difficult and have invested over $8 trillion in ETFs. If you’ll be able to’t beat the benchmark, put money into the benchmark. This may sound easy and somewhat boring, however it is an efficient solution for many investors.
Direct indexing is the alternative of ETFs and a step backwards for investors. Like ESG or thematic investing, the sort of investing is not free. Investors must know that their decisions come at a price. Since most investors have underfunded their retirement savings, they need to try to maximise their returns and avoid unnecessary risk.
Fully tailored portfolios have historically been reserved exclusively for wealthy clients. Maybe they need to stay that way.
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Photo credit: ©Getty Images / Aaron McCoy
