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Direct Indexing Projected to Outpace ETFs, Mutual Funds

The size of the retail direct indexing SMA market is small. At least right now.

Last year, some asset management executives called direct indexing an "overhyped" trend. But a new report suggests direct indexing in retail separately managed accounts is set to surge as more financial advisors leverage the platforms.

Assets in direct indexing separately managed accounts (SMAs) are projected to grow at an annualized rate of 12 percent over the next five years, outpacing mutual funds, ETFs and separate accounts, according to Cerulli Associates, a Boston-based research and consulting firm.

The size of the market helps explain the projected growth leader. The total sum of retail assets doing direct indexing is tiny compared to what is already invested in ETFs, mutual funds or more traditional SMAs. Cerulli estimates total retail assets using SMAs to direct index is just $360 billion. Trillions of dollars are invested in ETFs and mutual funds, respectively.

Lower trading costs and fractional shares mean better optimization and customization for more investors. “Advisors can scale direct investing across customized taxable accounts to provide pre-tax performance, offset expected and unexpected capital gains, streamline rebalancing, and provide flexible funding options,” Tom O’Shea, a director at Cerulli, said.

Still, mass affluent investors with financial advisors are unlikely to use direct indexing.

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It is not meant to be an investor’s entire portfolio, said Bing Waldert, managing director of U.S. Research at Cerulli. “You might be able to invest $250,000 in this but you have to own other things side by side with that to have a truly diversified portfolio. So, to get there, you're probably looking at someone who's at least a $2 million to $3 million investor,” Waldert said.

Direct indexing often requires high asset minimums to invest. Parametric Portfolio Associates, for example, has a minimum of $250,000 to open an account, according to Cerulli.

Tax optimization remains the largest benefit to investors, according to Cerulli, but advisors can also use direct indexing to customize investment strategies around ESG and other factors.

Although the current market for retail direct indexing is relatively small, asset managers have already acted with its projected growth in mind.

Over the past year, Morgan Stanley acquired asset manager Eaton Vance (which owns Parametric); BlackRock bought Aperio; Charles Schwab acquired some remains of Motif; and Vanguard acquired Just Invest.

Others remain independent, like venture capital-backed Vise, and Ethic, which has also raised capital and continues to grow.

Holly Deaton (@HollyLDeaton) is a staff writer at RIA Intel and based in New York City.

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