You may have read about it in the financial press. Your clients may be asking about it. Here’s a short primer to help you understand it.
If you’re not sure what direct indexing means, you’re not alone. As a term of art, it’s still fairly new. It’s also ambiguous. As our compliance team never fails to remind us, you can’t invest directly in an index. So what exactly is direct indexing?
The first thing to note is that while the name may be new, the strategy isn’t. In fact, it describes what Parametric has been doing for about 30 years: providing an alternative to index mutual funds and other vehicles for investors who want more choice, greater flexibility, and the potential tax advantages that commingled investments simply can’t offer.
Direct indexing has also been making the news lately. A number of providers (Parametric included) have been strategically acquired by larger industry players, pundits have been talking about whether direct indexing will disrupt the industry, and this past August, Cerulli Associates published an extensive research study on direct indexing. (Full disclosure: Parametric sponsored the study.)
I’ve written extensively about direct indexing on our blog and spoken about it at a number of industry events over the past few years, but I want to use this opportunity to take a step back and define direct indexing, answer some common questions about it, and help advisors and their clients understand who may stand to benefit the most from it.
What is direct indexing?
Most of us are familiar with mutual funds and exchange-traded funds (ETFs), which package underlying securities into a single vehicle accessible to investors. Investors purchase shares in an index-tracking ETF, for example, to gain broad market exposure to the benchmark of their choice—the S&P 500®, the Russell 3000®, and so on.
Direct indexing takes this idea in a different direction. Instead of owning shares in a commingled fund, the investor owns the individual securities in the portfolio directly, in a separately managed account (SMA). The investor gets the same kind of broad market exposure but with compelling advantages, including when it comes to improving after-tax outcomes. For example, unlike an ETF, direct indexing allows investors to customize their portfolios to actively harvest capital losses from individual securities. (More on this below.)
Direct indexing, done right, also unlocks other powerful customizations that allow investors who want broad market exposure to step outside what an index provider decides should be in their portfolio. For instance:
- If the investor has ESG principles they’d like to express, they can adjust their holdings to screen out certain industries or particular companies whose business practices they object to.
- If they have a concentrated position in a particular company’s stock, they can avoid redundant or risk-concentrating holdings in their portfolio.
- If they have convictions about certain types of securities—those considered value or momentum stocks, say—they can employ direct indexing to tilt their allocation to favor those characteristics, or factors.
- Investors aren’t limited to a single benchmark. They can combine multiple reference benchmarks to achieve the precise exposure they seek.
In other words, direct indexing takes the one-size-fits-all approach of commingled investing and turns it on its head, helping advisors add compelling value to a passive portfolio and tailor it to each individual client’s circumstances and values. What’s more, direct indexing’s direct ownership of individual securities offers powerful flexibility around charitable giving and estate planning. And direct indexing isn’t limited to equities. You can build a direct indexing custom SMA using fixed income too.
Does all this customization mean direct indexing isn’t truly a passive form of investing? Some subscribe to this point of view, arguing that direct indexing is instead a unique form of active investing. A reasonable position. But regardless of what we call it, it’s clear that investors are increasingly seeking a way of capturing market-like (or beta) returns on their own terms—an index of sorts that they can build and control.