The topic of ‘index customization’ has been gaining momentum of late. The strategy is expected to grow faster than other investment vehicles over the next four years as investors’ desire for personalization intensifies. Although this new approach is and will remain smaller in overall size than its larger assets-under-management brethren, as it moves more mainstream, its growth rate is expected to exceed that of ETFs, mutual funds and retail separate accounts as more firms step into mass customization.
Wealth and asset managers alike have been looking past earlier themes and strategies that relied on robo-advisers. The focus now is on the tax-management and customization features of direct indexing to create a more favorable client experience. Furthermore, direct indexing offers advisers the flexibility to match ESG factors with their clients’ preferences and values.
What has changed recently?Generally, investors would typically buy an ETF or mutual fund for exposure to a particular index but investors now have more flexibility and options to customize a portfolio. Thus, rather than buy a predetermined basket of stocks, they can buy stocks and weight the holdings based on their preference.
Companies will need to be mindful of certain changes impacting:
Enhanced focus on ESG
Ownership profile shifts
Proxy voting authority.
Direct indexing and custom originsAs the financial services and asset management industry continues to evolve, moving from the creation of index funds in the 1970s, ETFs in the 1990s and robo-advising in the 2000s, direct and custom indexing are the newest entrants to the portfolio management toolbox.
Direct indexing essentially allows investors to cherry-pick which stocks to buy within a benchmark index instead of owning a fund that tracks a specific company set, such as the S&P 500 or Nasdaq 100. The enhanced experience makes it easier to create, monitor and rebalance an investor’s own custom index, as well as buy, sell and rebalance an entire basket with one-click trading, in some cases.
Direct indexing ‘allows advisers to customize at scale because they can do some clicks with a button and implement ESG, take away certain stocks, and so on,’ said Jamie Catherwood, O’Shaughnessy Asset Management's client portfolio specialist, on the December 5 episode of Bloomberg ETF IQ. Franklin Resources bought O’Shaughnessy in September 2021 for its custom-indexing business Canvas. Research provider and consulting firm Cerulli Associates expects assets in direct indexing to climb to $825 bn by 2026 from roughly $462 bn now (at a compound annual growth rate (CAGR) of 12.3 percent), according to the firm’s December 2022 white paper, sponsored by direct-indexing provider Parametric Portfolio Associates.
‘Competition continues to intensify in the wealth management industry as investors exercise more control over their portfolios and providers are challenged to differentiate,’ the Cerulli white paper notes. ‘This has continued to amplify industry interest in direct indexing and, more broadly, mass customization of client portfolios.’
IR and institutional ownership trendsDirect indexing has been driving increased M&A within asset management providers, as numerous asset and wealth managers acquire technology-driven companies that allow for scalable customization of portfolios and tax management of investments. In addition to Franklin/ O’Shaughnessy, in 2020 BlackRock purchased Aperio for $1 bn, and Morgan Stanley paid more than $7 bn for Eaton Vance and its custom portfolio business Parametric.
In the first half of 2022, First Trust acquired Veriti Management to gain access to its direct-indexing platform. Even so, Parametric Portfolio Associates remains the largest provider of direct-index separately managed accounts, overseeing a sizable $183 bn in equity assets under management, according to FactSet.
Despite the growth rates, total assets in direct indexing are and will remain overshadowed by ETFs and other products. As noted in the chart (see previous page), capital in ETFs is projected to climb 9.5 percent to $11.3 tn in that span, while separate accounts are projected to rise 7.2 percent to $2.5 tn.
Monitoring current ownership profile changes is highly recommended to help ensure efficiency of all investor interactions and engagements.
Retail investor trendsWhile the direct-indexing approach remains a focus of wealth management, it is beginning to move more mainstream and travel down market to retail investors. In early 2022, Fidelity announced plans to offer a $5,000 account minimum direct-indexing solution, allowing retail investors to customize on several pre-selected factors and screens through its Fidelity FidFoliosSM.
Additionally, trading software, fractional share ownership and advanced portfolio-optimization software have all advanced to the point where this solution can be offered as a scalable, cost-effective solution for retail clients.
Meanwhile, one potential drawback is cost. Compared with most funds, direct indexing is costlier but the higher costs can be offset by the benefit of tax-loss harvesting, which is a principal focus of the direct-indexing approach.
ESG impact: Customization can fill a voidGiven its highly customizable nature, direct indexing fits exceedingly well with ESG investing, allowing advisers and investors to work with their direct-index provider to build portfolios that best match their or their clients’ goals, objectives, beliefs and values.
The approach seeks to replicate indexes while excluding securities that investors don’t want to own (usually those with fossil fuel exposure or other environmental concerns). As such, the flexibility of direct indexing provides investors with varying paths to implement ESG investments that are most relevant to them.
The ability to tailor an index-based product to personal values fills an important void in existing sustainable portfolio offerings. Some investors may want to exclude certain industries or sectors, while others seek impact investing or pairing direct indexing with donor-advised funds to advance a certain cause.
The customization of a direct-index offering is appealing as the core of an ESG portfolio, where advisers can then go out and add additional thematic elements in a satellite approach.
With traditional passive and active investment offerings, there is no inherent seat at the table in determining what is held in the fund. Proprietary ESG scores and methodologies, as well as decisions of active portfolio managers to invest/divest, prevent a complete personalization of one’s values.
With direct indexing, investors can start with a traditional (or ESG) index-based product and add a personalized overlay, specifying sectors, industries, sub-industries and even companies they wish to avoid. Direct indexing allows investors to choose only issues relevant to them and controls for climate change, deforestation, pollution, water stress, data privacy, diversity, labor rights, corruption, gender diversity and/or governance structure.
Direct indexing ‘is a result of the evolution of ESG and socially responsible investing,’ explains Andy Kunzweiler, portfolio manager in Morningstar Investment Management’s direct-indexing business. With mutual funds, ‘the investor – the end-user – really gives up control over the definition of ESG or what constitutes a suitable investment to the index provider.’
Proxy voting authorityIn addition, direct indexing allows investors to directly exercise their proxy voting rights if they so choose. Generally, this is not an option when owning index ETFs and mutual funds, where proxies are usually voted by the asset manager. Companies should have a clear understanding of their institutional/retail shareholder mix. As companies consider changes to their ownership profiles, it will be particularly important to consider how voting authority may impact the solicitation process.
Morrow Sodali is a global corporate consultancy that provides clients with comprehensive advice and services relating to corporate governance, compensation, ESG, sustainability, proxy solicitation, capital markets intelligence, shareholder and bondholder engagement, M&A, activism and contested situations, financial communications, investor relations and research. The addition of FrameworkESG represents Morrow Sodali’s seventh acquisition.
From headquarters in New York and London and offices in global capital markets, Morrow Sodali serves more than 1,000 clients in more than 80 countries, including many of the world’s largest multinational corporations, both listed and private, mutual fund groups, stock exchanges and membership associations.
