Sooner or later – and these days, usually sooner – the newest trends from wholesale investor-land trickle down to retail portfolios, as the pace of innovation in financial services speeds up.
“Direct indexing” could soon be the next vehicle to enter the fray. Direct indexing allows investors to alter existing indices to create bespoke portfolios that can include tilts to investment factors, such as value or growth, or to express their environmental, social and governance (ESG) preferences.
Where indexing as an investment concept started with low-cost “index funds” with the simple objective of approximating the well-established broad share market benchmarks such as the S&P 500 index, the principle – particularly in the exchange-traded fund (ETF) sector – has given birth to sector-specific indices, as well as ones specifically created to tap into certain high-growth areas of opportunity that have usually only been associated with active managers – themes such as cyber-security, robotics and artificial intelligence (AI( and clean energy. A symbiotic industry of index providers has grown-up, that can create the index for a vehicle to follow to invest in a theme.
It was only a matter of time before indexisation became even more targeted; and direct indexing is the result. Direct indexing allows investors to create a personalised index in a separately managed account (SMA). Instead of accepting that they must own all the companies in an index, by buying an index fund, investors can use direct indexing to exclude specific stocks, or industries within a sector, or even entire market sectors. In effect, direct indexing would allow investors to view the existing index as a starting point rather than the ending point; and add or ditch companies from it according to their own preferences and requirements.
It’s done through technology, using “big data” analysis, quantitative algorithms and risk modelling to build customised portfolios. And the nascent direct indexing sector has just received the blessing of the biggest index investor of them all, the US$7.9 trillion ($10.5 trillion) Vanguard – the world’s second-largest asset manager – which earlier this week announced that it had agreed to buy Just Invest, a California-based wealth management boutique that builds customisable, direct indexes. Vanguard’s move follows similar deals by heavyweight rivals BlackRock and JPMorgan.
With its focus on individualisation, direct indexing will hit two sweet-spots of investor demand: tax-efficiency and environmental, social and governance (ESG) considerations.
Daniel Wiener, the editor of the Independent Adviser for Vanguard Investors newsletter, was quoted saying that moving into direct indexing could enhance Vanguard’s reputation for running tax-efficient portfolios. “While Vanguard’s funds are already extremely tax-efficient, direct indexing will allow some investors to generate losses that can be used to offset gains in other parts of their portfolios,” said Wiener.
Direct indexing uses the “tax-lots” principle, by which every individual “parcel” of stocks bought in the process of assembling the portfolio has its individual capital gains situation based on the stock price at the time of purchase. The capital gain or loss on each parcel will be different. Every parcel is monitored for risk and tax-loss harvesting opportunities – at the end of the financial year, parcels with prices that have fallen below their cost basis present “loss-harvesting” opportunities. The investor can sell loss-making parcels to offset capital gains on others (in Australia, the investor would be able to choose to their advantage, whether to sell a parcel with a capital loss to realise the loss immediately, or keep a particular parcel until it has been held for a year, to qualify for the discounted capital gains tax rate.)
The other sweet spot is ESG investing – direct indexing allows investors to express ESG preferences by excluding (or adding) stocks based on individual criteria, and effectively personalise the index. For example, an investor who wanted to track the Dow Jones Industrial Average but did not want to invest in fossil-fuel production could, through direct indexing, hold the Dow Jones minus Chevron.
Another benefit could be lessening the overlap between an index and the individual’s existing shareholdings – the investor can construct an “index-minus-my-own-holdings” exposure, to maximise portfolio efficiency.
In the US, some robo-investment fintech services offer direct indexing, mainly for tax-loss-harvesting; and other new techniques – for example, fractional investing, which allows investors to buy, say, $1,000 worth of a Berkshire Hathaway Class A share, instead of having to pay US$421,350 for one share – are also opening-up opportunities for more individualised investment exposures.
Industry commentators in the US have pointed out that just as exchange-traded funds (ETFs) disrupted the managed funds industry in the early 2000s, direct indexing carries the same threat to ETFs – although the simplicity of ETF exposure in the hands of the end-investor will still be attractive to many. The administration burden on direct indexing is still large – for example, the need for regular rebalancing – but fintech companies are chipping away at this all the time. Some of the issues involved are covered well here.
Australia’s index fund and ETF sectors will be keeping an eye out for direct indexing; as will the $86 billion managed accounts sector in this country, for which it offers potentially big opportunities. No-one is doing it here yet: a Vanguard Australia spokesperson says the firm’s foray into direct indexing was “very much a US initiative,” while a major ETF provider would only say that direct indexing was “on their radar, but it’s a little early for Australia.” But you can bet your bottom dollar, it will come, and to the retail market.