A new report just threw cold water on a hot topic in investment management this year: direct indexing.
Direct indexing was not new in 2020. Investment managers have long been forgoing index mutual funds and exchange-traded funds in favor of separately managed accounts, allowing them to pick and choose stocks to boost returns, lower taxes, or customize an equity allocation to a client’s liking. Historically, SMAs have only been for the wealthiest private investors and institutions with portfolios big enough to justify the costs.
But investors crave alpha and customized portfolios as much as ever, and changes over the last year to the costs, flexibility and sophistication of trading, made direct indexing a renewed subject of interest in 2020. Offering direct indexing to affluent and mass-affluent investors could be a boom for any company that does it.
Last fall, Charles Schwab disrupted part of the financial services industry when it eliminated commissions to trade stocks, ETFs, and options for retail investors and the more than 7,500 RIAs that custody with the firm. Shares of TD Ameritrade, which it acquired shortly after, and other competitors tumbled on the news.
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“The collapse in trading fees has made a difference. Direct indexing used to be for someone with an account worth at least a half a million bucks. Now you can do it all at scale,” an executive told Cerulli Associates.
Since then, more companies have also begun offering fractional shares or, it seems, sought to catch up to others that were.
Altruist, a new commission-free custodian to RIAs, launched and began offering fractional shares. Schwab bought the remains of Motif, the portfolio management company that suddenly ceased operations. Goldman Sachs acquired Folio Financial, a self-clearing broker-dealer and technology company.
Vise, which uses artificial intelligence to help advisors build and manage portfolios down to the individual stock, raised a $14.5 million Series A round of funding led by Sequoia Capital. “We see our competition more being the incumbents in this space, so the same SMA, UMA money managers, and those types of third-party managers, and mutual fund companies like DFA or Franklin Templeton, just those incumbents being our biggest competition, not necessarily the robo-advisors. We think that we’re the next step in the evolution to that whole space,” Vise co-founder and CEO Samir Vasavada told RIA Intel in May.
One managed account executive is eager to achieve that level of customization for the masses. “That type of business is the Holy Grail tailored to individual clients…putting in customized tilts so you manage the portfolio even better,” he told Cerulli.
Others aren’t as excited.
Although 26% of executives surveyed by Cerulli Associates, a Boston-based research and consulting firm, said there is “significant opportunity” in direct indexing, “a sizable proportion of executives surveyed by Cerulli believe the market for direct indexing has been overhyped,” according to a report published Monday.
Nearly half, or 44%, of the executives indicated to Cerulli there is little business opportunity in direct indexing intended for less-wealth clientele, for a few reasons.
“Several point out that only a handful of firms with a strong history of passive investing and technological wherewithal to develop dashboards necessary to roll it out to advisors will dominate the market for personalized index portfolios,” Cerulli said.
Other executives told Cerulli that distributors will develop proprietary products and compete with third-party solutions, making it even harder for them.
There is some potential in direct indexing for less-wealthy clients if delivered through SMAs as model portfolios, but that practice is rare, according to Cerulli. On an asset-weighted basis, mutual funds and ETFs are the most common investment vehicles that models allocate to, averaging 99.7% of assets among model providers reviewed by Cerulli. Separate accounts represented just 0.3% of assets.
And one senior executive at a large managed account sponsor told Cerulli: “I have heard [direct indexing] come up, but it’s not at the top of our list for the roadmap. I think it’s interesting, but we have a backlog of other stuff to do. I’m always trying to figure out…is this a real macro-economic thing or just a fad? There’s a lot of faddish stuff we don’t waste our time on.”
Michael Thrasher (@Mike_Thrasher) is a reporter at RIA Intel based in New York City.
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