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Direct indexing predicted to see huge growth in the US

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December saw publication of Cerulli Associates’ report on the rise of direct indexing. The firm explains that, in the context of the US, leading direct indexing solutions are customised separately managed accounts (SMAs) that provide investors direct ownership of individual securities in an index-like solution. 

Cerulli writes that the primary objective is beta exposure that can be customised and

improve outcomes by leveraging tax efficiencies, ESG, factor tilts, and thematic

investing. 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 firm says.

Direct indexing allows investors to directly own all or a customised assortment of the individual securities in an index, without purchasing a fund.

The firm writes: “Unlike mutual funds or ETFs, direct indexing provides individual portfolios with greater control to harvest gains and losses throughout the year on the individual security level. It provides this flexibility without significant drifting from the client’s risk tolerance and desired tracking error or needing to sell an entire fund to tax-loss harvest.”

Cerulli predicts that direct indexing assets will grow to USD825 billion by end of 2026, and the authors note that there is little awareness of the facility with just 14 per cent of US advisers aware that such a thing exists.

Blackwater Search & Advisory has also published a study on direct indexing, citing data from Parametric which reveals that in 2021 direct indexing represented approximately USD350 billion in the US. The firm writes that the rate of growth of direct indexing over the next five years – estimated at 12.4 per cent – will outpace that of other products like ETFs and mutual funds. 

The firm believes that direct indexing is more than just a marketing gimmick, commenting that it truly brings an upgrade to SMAs with lower fees and better technology, but also notes: “It is not exactly an ETF killer either, as ETFs remain an attractive solution for cost-focused retail investors with small investment amounts.

“Not everyone needs or wants the degree of customisation that direct indexing offers, and the variety of funds already existing on the market is more than enough to craft interesting portfolios that can reflect the values and interests of most investors,” the firm says.

“On top of costs considerations, the current direct indexing offer is much less diversified than that of ETFs in terms of asset classes available. Most direct indexing providers focus exclusively on stocks, as bonds remain more challenging to hold for individual investors as they trade less, and in larger lot sizes. For now, real estate and commodities are out of the conversation entirely.”

There is also the point that direct indexing mostly happens in the US, with no official direct indexing solution marketed in Europe so far. The closest alternatives are a few robo-advisers offering investors the option to exclude certain stocks from their portfolio, Blackwater notes.

The Cerulli survey found that fewer than one in five European ETF firms says they expect to develop a direct indexing proposition.

Blackwater concludes that direct indexing is the asset management industry’s attempt at breaking away from the ever-more-powerful index providers, regaining both some control and a portion of the fees. 

“It is mostly constricted to the US so far, and the most successful providers have already been bought by large asset managers,” the firm says.

“Still, it is a step backward for most investors as it combines all the issues of direct investing and none of the benefits of index investing. While some degree of personalisation serves a better alignment of interests between firms and clients, giving mass retail investors full autonomy with their investment decisions might prove detrimental to their long-term returns, failing the industry pledge of working in the ultimate benefit of investors. All in all, direct indexing is an interesting but niche service right now most beneficial to specific high-net-worth US investors. Will it remain so? Only time will tell,” the firm concludes.

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