Could direct indexing be the next portfolio management frontier?

Just as ETFs disrupted mutual funds, direct indexing offers features for even better customization

Could direct indexing be the next portfolio management frontier?

While ETFs still represent only a small slice of the Canadian investment-fund industry, continued growth in the segment clearly shows how features like low cost, liquidity, and transparency are resonating with investors. But even as ETFs challenge the dominance of mutual funds in Canada, another developing trend appears set to overtake ETFs in the US.

“Big institutional players have traditionally directly invested in stocks, rather than wrapped products such as funds and ETFs,” said Vijay Vaidyanathan, PhD and CEO of Optimal Asset Management, in a recent report on WealthManagement.com. “Now, as a result of technological advances, directly investing in stocks, aka ‘direct indexing’ is coming to Main Street.”

Speaking at Inside ETFs’ February 2019 conference, Inside ETFs Chairman Matt Hougan reportedly touted direct indexing as “the next US$100-billion advisor opportunity.” The practice opens the door for investors to benefit from stock-level tax-loss harvesting and capital-gains deferral, as well as other customization and tax-management practices.

When they first entered the scene, ETFs offered something better than mutual funds. Instead of dealing with expensive loads and fund minimums, investors had the choice to buy index-based or other types of ETFs like a stock. There were also other appealing features like intraday tradability, the chance to employ margin, easy diversification, and the elimination of obscure capital-gains distributions for long-term mutual funds.

But as ETF.com CEO Dave Nadig explained, they’re not a flawless vehicle to get people to and through retirement. “ETFs are pretty good transport—tax-efficient, low costs, etc.—but they aren't perfect,” he said during the conference. “They are not tax maximized; trading is not always good, as the late John Bogle has said.”

Going one big step further than ETFs, direct indexing lets the investor add or cut specific investments. An investor who likes a certain portfolio but would rather eliminate or add a specific stock can tell their advisor, who can then implement the preferred index in a separately managed account. Broader customization, such as country- or sector-level additions or cuts, is also possible.

Another advantage of direct indexing comes from the tax-loss harvesting opportunities it provides. By selling securities at a loss and replacing them with similar assets, investors can offset capital gains in other parts of their portfolio. The result is an asset allocation that’s largely unchanged, except for the tax benefit. Since ETFs consist of entire baskets of stocks, they don’t have the flexibility and customization characteristics needed to execute tax-loss harvesting strategies perfectly.

While Hougan and his peers do not see ETFs going away, advisors who are competent at using both ETFs and direct indexing will have a valuable edge. As a fairly new concept, direct indexing represents an opportunity to educate the broader public and possibly gain new clients in the process. Explaining how direct indexing can help people achieve their financial goals can stir up new levels of excitement among new and prospective clients alike.

“Direct investing allows financial advisors to go beyond goal-based investing as a planning tool, and use it as a tool to actually shape the outcomes that each client’s goals require,” Vaidyanathan said. “With direct-index investing, the advisor knows that a customized solution to shape the investment outcomes to achieve those goals can be easily created.”

 

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