Direct Indexing: ETFs — Friend or Foe

April 2019

Since 2014, direct indexing has been thought of as a potential threat over the ETF industry, but only recently has it become more prevalent. Direct indexing has many advantages that have come to the forefront in recent years: enhancements in portfolio construction, tax harvesting and the demand for passive products. Though these are not new ideas, reduction in transaction costs and technology advancements in creating and customizing indexes have led to the cost and operational efficiencies that have produced an increased focus on these products.

The main difference between direct indexing and index funds is that the investors own the underlying shares. This gives them the advantage to take tax losses on underperforming securities in the portfolio. The overall tax advantage of that process versus the tax advantages of ETFs can be argued, but the results might be negligible. However, that tax advantage versus a mutual fund can be as significant as the advantages of ETFs versus mutual funds.

The advances in technology have simplified the direct indexing process. Creating indexes on Excel has been transported to more systemic processes, yielding more sophistication to product development. There have also been operational improvements in delivering trading instructions and rebalancing data.

Direct indexing has become the next disruptive product in the financial services industry. There have been many discussions about innovation in ETFs and the potential loss of it because the industry is so tied to just three firms — iShares, Vanguard and State Street. Maybe direct indexing is not about ETFs but an additional delivery mechanism to provide investors with the access to passive investment strategies. It is also being seen by traditional ETF providers and indexers as a potential new distribution channel.

There will always be investors who do not want to use ETFs for various reasons and may be willing to pay higher fees to have more control of their portfolio or let their trusted advisor have more access through direct indexing. Thus, this new disruptive process might be more of a threat to active mangers than to passive. They carry the same performance risk as an active manager because of potential tax loss, selling at the wrong time and customizing the portfolio by using a smaller sample of securities than the benchmark.

Direct indexing could also become a boon for ETFs. If direct investing is reaching RIAs who are moving out of actively managed products and their first move to passive is direct indexing, then their next move might be into ETFs. There are still large numbers of RIAs who are not well educated in ETFs, but direct indexing may be the vehicle that strikes their curiosity and eventually pushes them into ETFs. Fee structure could be that trigger point. ETFs are still significantly less than a traditional SMA or direct indexing account.

One group that is all in on the direct indexing craze is the indexers themselves. Fees paid to indexers on direct indexing platforms are more robust than what they are receiving from licensing an index to an ETF provider. The challenge is the depth of indexes on these platforms and how to differentiate your index from others. Brand is less of a differentiator, and index construction is highly vetted by the advisors using these platforms. Performance matters.

Direct indexing is the new disruptive process circling the ETF industry, but it just may be more friend than foe.

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