The Mirage of Direct Indexing

A rare free lunch?

November 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Direct indexing is one of the growth areas in the asset management industry
  • However, direct indexing represents active management, specifically an inferior approach to it
  • Given the poor track record of active management, most investors should avoid pursuing this

INTRODUCTION

Direct indexing is hot. In October 2020, Morgan Stanley bought the asset manager Eaton Vance primarily for its direct indexing subsidiary Parametric. BlackRock followed one month later by purchasing Aperio, the second-largest player in the space. This year, JPMorgan bought OpenInvest in June, Vanguard took over their partner JustInvest in July, and in September, Franklin Templeton acquired O’Shaughnessy Asset Management (OSAM) and its Canvas direct indexing platform.

The giants of the asset management industry are clearly intrigued by direct indexing and it’s not hard to see why. The rise of exchange-traded funds (ETFs) has steadily eroded the management fees of mutual funds and of ETFs themselves, and with more than 2,000 US ETFs and 5,000 US equity mutual funds all based on a universe of only 3,000 stocks, there is little room left for additional products. The industry is looking for new revenue-generating business areas and growing client interest in customized portfolios has not gone unnoticed.

Direct indexing should be an easy sell for the marketing machines of Wall Street: A portfolio can be fully customized to the client’s preferences by, for example, excluding any stocks that contribute to global warming or prioritizing high-quality domestic champions. On top of that, tax-loss harvesting can be offered. And all of this in a fairly automated fashion using modern technology stacks at low cost (read Indexing: Out with Tradition?).

Like many proposals in investing, direct indexing seems like a free lunch that is too good to pass on. But is it?

AN OVERVIEW OF DIRECT INDEXING

Although firms like Parametric have been offering direct indexing to their clients for decades, the market’s AUM really started to grow since 2015. Over the last five years, direct indexing’s AUM expanded from $100 to $350 billion. In part, this is due to the software-creation te