Is This Direct Indexing’s Moment?

Brandon Thomas, CIO of Envestnet, talks about the recent growth of the strategy and what is behind it.


Illustration by RIA Intel

Envestnet, the wealth management software firm used by more than 106,000 financial advisors representing $5 trillion in assets, has seen explosive growth in its direct index offerings.

According to the company, its internally managed direct indexing solutions have grown by 40 percent annually in accounts and advisors over the past three years.

“Direct indexing has become the most popular strategy on the Envestnet platform. We’ve had tremendous adoption from advisors,” said Brandon Thomas, Envestnet CIO and co-founder.

The company launched its first direct indexing strategy in 2013 to provide clients with a passive strategy that combined tax management and customization. Since then the company has grown to be the eighth largest direct index separately managed account provider with $4.4 billion in assets as of the fourth quarter of 2022, according to Cerulli Associates.

According to Cerulli, direct indexing is projected to outpace mutual funds, ETFs, and separate accounts over the next few years. Fidelity’s most recent RIA benchmarking study found that about 38 percent of RIAs managing more than $1 billion in assets offered direct indexing, while just 11 percent of firms managing less than $1 billion said the same.

Thomas sat down with RIA Intel to discuss the benefits of the strategy and why he thinks it has grown so quickly. Responses have been edited for clarity and length.

What is direct indexing and why do many people consider it an overhyped trend?

The term direct indexing is a relatively new term but it’s a strategy that’s been around for decades. You know, Dimensional Fund Advisors and AQR, have been applying this type of approach for many years. Vanguard has been a direct index manager since 1976.

When a new label is assigned or coined, there’s always a danger that it’s going to be considered a fad. But I’m not really concerned about that because there’s substance to this type of investing. At its heart, direct indexing is a separate account strategy that holds individual securities. They are designed to be tethered to an index and are quantitatively managed. They are not trying to outperform the index, they are designed to replicate the strategy while providing additional tax benefits and client customization.

What are other advantages of going the direct indexing route versus just buying a passive ETF or mutual fund?

There are several substantive reasons and then there’s more of an optical reason. With a separate account strategy, where the client owns the individual securities, they can take advantage of a couple of things. Number one is the tax management. Yes, ETFs are tax-efficient, but you can do more within a separate account. Advisors could harvest more losses to offset gains. The second big benefit from a substantive standpoint is the personalization opportunities that you get in a separate account that you don’t get with any ETF. An ETF is a pooled account, so everybody gets the same holdings, but in a direct indexing separate account, you can personalize it. If a client came in and said, ‘Look, I work for a tech company and I’ve got a lot of Google stock. I don’t want to own any more Google in this portfolio you’re managing for me,’ we can restrict the portfolio from owning Google. There could also be sector restrictions like increasing or decreasing exposure to ESG or focusing on particular areas of the economy.

For optics, financial advisors don’t want to offer their high-net-worth clients an ETF strategy their clients can get that on their own. The advisor wants to give them some value add that goes above and beyond an ETF. They can go to the client and say look, ‘Rather than investing in an ETF, let’s invest in these direct index separate accounts that give you a tax management solution that is tailored specifically for your circumstances, and we can personalize it so that it aligns with your goals and objectives.’ Clients can’t buy these solutions on their own; they have to get them through a financial advisor.

You’ve mentioned that this type of investing has been around for a while, but I think the perception is that direct indexing is still in the early stages. What’s the disconnect?

The direct index strategies of today are really the realization of the promise of what separate accounts were back in the 1990s. Back in the ‘90s, some of the actively managed strategies applied tax management solutions but they did not offer much customization. But now, the way direct indexing has evolved is that this personalization is going to take hold. It’s a bespoke creation of model portfolios for a client, and then the tax management is really customized for that particular client’s needs. Historically, there weren’t many managers doing this. However, in the last couple of years, many managers have bought or acquired firms that provide them with the necessary capabilities to do this. Now that there are more managers, it’s becoming a little bit more prominent in the marketplace, and advisors are learning more about it and wanting the benefits they provide.

What are the drawbacks to direct indexing?

Not every investor has enough investable assets to qualify for these strategies. Minimums typically start at $100,000. Also, it’s often startling for an investor the first time they see their monthly statement. They can be taken aback at first by the number of holdings listed on that statement. Many investors are used to being invested in five mutual funds or ETFs and only having a single-page statement and now they hold 150 or 200 individual stocks. But that’s a good opportunity for the advisor to communicate with the investor and say to them ‘Every one of these positions in this portfolio that we’ve invested in, really is trying to achieve something for you from a tax perspective, from a personalization perspective, from an asset class exposure perspective.’

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