Advisor adoption set to increase as niche product’s advantages become clearer, says Cerulli
While it currently represents just a minority of investment industry assets, direct indexing is set to gain on more mainstream products and offerings in the next half-decade, according to Cerulli Associates.
In a new white paper, Cerulli estimated that as of 2020, direct indexing assets totalled US$362 billion, accounting for nearly one fifth of the total assets in U.S. retail separate accounts. Its use is restricted mainly to a small group of advisors for high-net-worth clients, the report said, even though it offers numerous advantages.
“Advisors can scale direct investing across customized taxable accounts to provide pre-tax performance, offset expected and unexpected capital gains, streamline rebalancing, and provide flexible funding options,” Tom O’Shea, director at Cerulli, said in a statement.
While it’s still a niche offering, direct indexing is expected to grow at an annualized rate of more than 12% over the next five years, according to the report. That compares to 3.3% for mutual funds, 11.3% for ETFs, and 9.6% for separate accounts.
Direct indexing possesses an edge over mutual funds or ETFs, Cerulli said, as it provides individual portfolios with finer control for harvesting gains and losses at the individual security level without straying outside risk and tracking error bands. While a pure direct indexing solution is best applied against a passive exposure to start, actively managed and highly customized separately managed accounts have also made inroads into the retail channels.
“The value proposition of retail separately managed accounts (SMAs) is similar to direct indexing—by owning the underlying securities in an index-like solution, clients can invest in a more tax-efficient manner than mutual funds, where they might be subject to embedded capital gains,” the report said. “Retail SMAs offer the potential for automated tax-loss harvesting, but just 16% of advisors are taking advantage of this.”
Beyond its tax-optimization potential, direct indexing can also provide for beta exposure to stocks based on other strategic priorities including ESG or responsible investing, factor tilts, and thematic investment. Leading advisors may also differentiate their services further through customizations to enable flexible onboarding and tax-optimized charitable giving, O’Shea said.
Direct indexing momentum is on the rise across the industry as the market for the product is expanding, Cerulli noted. Aside from applying direct indexing to novel asset classes, it said asset managers are acquiring direct indexing providers and bringing proprietary solutions to market.
“Even a modest increase in adoption among this segment can drive assets higher,” O’Shea said. “Our findings suggests [sic] that direct indexing will help wealth managers achieve a more robust service offering, fulfilling unique portfolio customization requirements from investors across the wealth spectrum.”
