Hollywood’s brightest stars took the stage at Sunday night's Academy Awards ceremony, but at last month’s Inside ETFs conference in the other Hollywood—you know, the one in Florida—it was direct indexing that seemed to bask in the spotlight.
A product that’s delivered in the form of a customized separately managed account (SMA), direct indexing was hailed as the next big thing in investing at last year’s conference. Flash forward to this year, and we’ve started to see the impact direct indexing has had on the ETF universe. While some in the ETF community value what it has to offer, others are frightened by misconceptions that paint direct indexing as a threat.
So as the CEO of a company that provides custom SMAs, my speaking role at Inside ETFs was a bit counterintuitive—and probably even more so when I chose the role of hype buster, poking at the hyperbole surrounding direct indexing.
Direct indexing has been called the ETF killer, ETF 2.0, and a catalyst that will bring an end to commingled investment vehicles. I do think there’s enormous potential for direct indexing to become a lot bigger than it is today. But to make proper use of all its benefits, we must flip the script on the narrative of direct indexing to show not only the importance of customization but also that its value comes from understanding how and when to use it.
Direct indexing: The benefits of customization
The first thing to understand about direct indexing is that customization is everything. The opportunity for tax-loss harvesting on individual securities to achieve higher after-tax performance, to tailor ESG criteria to each client’s principles, to tilt a portfolio to factors such as value or momentum—all this means that no two custom SMAs need be alike.
And it’s not just investors who benefit. Advisors who offer it get to create something that builds a foundational connection with their clients.
But direct indexing isn’t for everyone
The value of customization can vary depending on an investor’s specific profile, but the ideal candidate is an investor who, among other things:
Those who have profiles that don’t align with customization might not see much value in direct indexing—especially after considering the product from a cost perspective.
That’s right, customization does have costs. Relative to commingled vehicles such as ETFs, custom SMAs have higher fees, more tracking error, and added operational complexity. Many investors who don’t naturally benefit from customization—at least beyond its costs—should continue to get their market exposure through funds and ETFs.
But it’s important to add that funds and custom SMAs aren’t mutually exclusive. ETFs have—and will continue to have—a powerful place in the investment ecosystem.
Customized SMAs: A high bar
New direct indexing providers tend to underestimate the challenges created by customization and focus exclusively on the technology by way of algorithms, portfolio construction, and user interfaces. But that’s only part of the script, since providers need a full cast of distribution, marketing, client consultation, implementation, and service to deliver and defend the promise of customization. This is a high bar. That’s why the majority of market share tends to go to providers with established technology and intellectual property, a track record of success, and teams of people with the experience to deliver with ease.
The bottom line
Our job at Parametric is to get people with the right use cases to understand the value of customization. That’s why advisors should think hard about both the benefits and costs of direct indexing. Because the last thing an advisor should do is cast a client in a role—or put them in a portfolio—they’re unsuited for.