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Editor’s Note: This is the start of a three-part series on direct indexing.

Direct indexing, a process which lets investors engage in hyper-specific index investing, is experiencing a surge in popularity.

The index-like investment solution is on pace to grow at an annualized rate of more than 12% over the next five years, faster than traditional financial products such as mutual funds and exchange-traded funds, according to research firm Cerulli Associates.

Customized separately managed accounts that provide investors direct ownership of individual securities in an index-like solution are the more popular direct indexing solutions, according to Cerulli.

The primary objective is beta exposure that can be customized and improve outcomes by leveraging tax efficiencies, environmental, social and governance strategies, factor tilts and thematic investing, Cerulli said. Unlike mutual funds or ETFs, direct indexing provides individual portfolios with greater control to harvest gains and losses at the individual security level while staying in risk and tracking error bands, the research firm added.

“Direct indexing’s most quantifiable value is tax optimization and the resultant tax savings,” Cerulli director Tom O’Shea said in a statement. “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.”

In contrast to investing in an index fund or an ETF that tracks an index, direct indexing involves buying the individual stocks of an index weighted according to preference and placed in a separately managed account.

The benefits of direct indexing are increased customization and an enhanced ability to maximize tax revenues, according to Rahul Sen Sharma, managing partner at Indxx, which produces custom indexes for clients.

For example, if a client wants exposure to the electric vehicles sector but already holds a significant position in Tesla, they might want an index weighted away from Tesla, Sen Sharma says. An electric vehicle ETF likely wouldn’t offer that level of nuance, he adds.

The tax advantages come into play when, for instance, one component of a direct index loses value. That component can be sold and the losses written off even as other components and the index as a whole gain value, Sen Sharma said.

Investors are jumping on the bandwagon, and wealth management firms are making moves. Direct indexing accounted for almost 20% — or $362.7 billion — of the total retail separate account assets in retail separate accounts as of the first quarter of this year, according to Cerulli.


Despite the advantages, direct indexing comes with two major drawbacks — buying the component parts of an index isn’t cheap, and reweighting a large index takes time and effort, according to Indxx’s Sen Sharma.

“You can’t do it with $20, you need some solid money. And it is more work. With an ETF, it’s set it and forget it,” he said. “This is a lot more work. You’ve got to pay attention to it, the rebalancing, the reconstitution, the names, screens — all these things still need to be done.”

Advisors must be aware that direct indexing will involve a lot more hand-holding of clients.

That work includes communicating with clients about the minutiae of what goes into making the index and the trades that are necessary to keep it properly weighted, so that they know what they’re getting into, Sen Sharma says. Then comes the actual time it takes to manage the portfolio, he notes.

Top Providers of Direct Index Separately Managed Accounts Q1 2021 Assets, in $ Millions Source: Cerulli Associates. Note: Assets are limited to U.S. clients. Figures do not include institituional assets, global/multinational accounts or bank trust accounts. Morgan Stanley (Parametric Portfolio Associates) $120,005 BlackRock (Aperio Group) $44,996 Fidelity Investments $24,000 Columbia Threadneedle $6,294 Natixis Investment Managers (Active Index Advisors) $4,736 Envestnet $3,408 JPMorgan (55ip and OpenInvest) $1,400 O’Shaughnessy Asset Management $1,227 Ethic $672 SmartX $171 Russell $50 Other industry assets $155,000 Total $362,667

Tomorrow: Direct Indexing: A Potential Revenue Stream, Recruitment Tool for RIAs

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