The proliferation of direct indexing is a key theme in U.S. asset and wealth management, with retail investors increasingly interested in customized investment solutions. Investors continue to embrace sustainability, further underscoring investor preference to align investments with their values and ethics. In 2020, $27.4 billion flowed into U.S. exchange traded funded (ETFs) focused on environmental, social, and corporate governance (ESG) practices. But the factors that determine whether an ETF meets ESG criteria is being questioned. The shift to index tracking and the potential to deliver a product that provides customized ESG and tax factors at scale presents a significant opportunity for underserved investors.
While separately managed account (SMA) programs are traditionally targeted for wealthy investors, advanced technology, low trading fees, and the rise of fractional shares have unlocked access to mass affluent clients further down the value chain. We explore the state of the market, emerging trends, and the revenue opportunity driving direct indexing.
Direct indexing can deliver customization and sustainability at scale
Direct indexing refers to tracking the performance of an index by buying a sample of individual stocks instead of an ETF or mutual fund. By owning the individual stocks rather than a bundled product, investors receive the benefit of greater control and customization. Driven by hyper-personalization and advanced technology, investors can now construct portfolios that reflect their personal values while benefiting from tax optimization.
According to Cerulli, 67%of asset managers believe direct indexing represents the most immediate opportunity to manage both tax and ESG factors. Customization enables investors to construct portfolios with more transparent ESG effect and tax benefits that ETFs do not offer. Against the backdrop of rising tax rates and decreased long-term return expectations, tax management is receiving increased attention. Data suggests effective tax overlay services can deliver tax alpha, or additional return, of 1-2% annually.
Custom indexes represent a new approach to a separate account structure without the high costs that have traditionally limited SMAs to high-net-worth and ultra-high-net-worth clients. This structure enables investors to own a portion of the individual companies that reflect their views in climate change, human capital, and corporate behavior. Asset and wealth managers are eager to tap into the underserved mass affluent market segment at scale.
Asset and wealth managers are prioritizing direct indexing as evidenced by 2020 acquisitions
Industry leaders in asset and wealth management made bold acquisitions in technology and the custom index space in 2020. Charles Schwab, a leader in zero trading fees and fractional share trading, acquired the technology of Motif in May 2020 to accelerate development of thematic and direct indexing technology. Morgan Stanley acquired Eaton Vance for $7 billion in October 2020; gaining access to Parametric, which manages $300 billion of direct indexing portfolios. And BlackRock’s acquisition of Aperio for $1 billion in November 2020 boosts it’s SMA AUM by 30% to $160 billion and represents a shift from BlackRock’s ETF business which totals $7.8 trillion in assets.
With integration efforts underway, the technology challenge will be twofold – provide transparent data that quantifies ESG impact and tax optimization; and build a tech-enabled application for a seamless advisor/client interaction. As custom indexing blurs the lines of passive and active management, financial advisors will require an effective interface to construct portfolios in consultation with their clients and communicate changes to portfolio managers.
Sizing the potential asset growth and revenue opportunity
According to the U.S. SIF Foundation, ESG assets totalled over $17 trillion in 2020, accounting for one-third of the total U.S. AUM. COVID-19 accelerated ESG growth, as there was heightened focus on workplace diversity and social issues. But despite the tremendous growth, ESG is still in the early stages of development. While there are currently more than 500 U.S. index funds focused on sustainability there is no uniform standard to track ESG metrics and the due diligence burden falls on retail investors. As the ESG investment landscape evolves, the preferred investment vehicle will need to accommodate the bespoke and tax-efficient preferences clients expect.
The U.S. retail SMA market totals $1.7 trillion while growing 15% annually and 35% annually among RIAs. Similarly, direct indexing has demonstrated strong growth at O'Shaughnessy Asset Management, an RIA that saw assets quickly eclipse $1 billion in AUM since launching in late 2019. These assets combined with Parametric, Motif and others point to staying power and strong growth potential. Although more expensive than ETFs, direct indexing product fees typically range from 0.15-0.35%, which is on par with robo-advisors and cheaper than many active mutual funds.
The cohort of high-net-worth ($1M-$5M) and mass affluent ($100K-$1M) individual investors controlling over $25 trillion in financial assets will continue to disrupt this space. To capture the strong growth in custom portfolios, asset and wealth managers need to develop a fintech solution that enables high-touch portfolio construction between advisors and clients. Delivering transparent data that quantifies ESG effect and tax alpha will be critical in supporting mass customization.
Increasing interest in tailored portfolios coupled with heightened asset manager focus suggests direct indexing will be a viable solution for investors seeking portfolios that meet their ESG criteria. While advocates anticipate direct indexing assets to soon exceed $1 trillion, skeptics do not expect a significant outflow from low-cost ETFs and predict demand from mass affluent investors to be muted. Although technology has enabled the rise of direct indexing, investor adoption in the near-term hinges on the ability for asset and wealth managers to deliver a seamless client/advisor experience.
1 Factset, Investors Pile Into ETFs Devoted to Socially Responsible ESG: https://www.wsj.com/articles/investors-pile-into-etfs-devoted-to-socially-responsible-esg-11608114604
2 Cerulli Associates, Direct Indexing Presents New Opportunities for Customization of Separately Managed Accounts: https://www.cerulli.com/news/direct-indexing-presents-new-opportunities-for-customization-of-separately-managed-accounts
3 US SIF, The US SIF Foundation’s Biennial “Trends Report” Finds That Sustainable Investing Assets Reach $17.1 Trillion: https://www.ussif.org/blog_home.asp?Display=155
4 Cerulli Associates, BlackRock to Acquire Aperio – Leading Provider of Personalized Index Equity Solutions: https://www.blackrock.com/corporate/newsroom/press-releases/article/corporate-one/press-releases/blackrock-to-acquire-aperio