By Randy Bullard, Global Director of Wealth Management, Charles River Development
Direct or personalized index portfolios have been utilized by high net worth investors for over 20 years. Firms like Parametric Portfolio Associates and Aperio have promoted them through separate account programs, and private client groups and individual financial advisors have implemented them directly for their high net worth clients. This slow but steady growth became an avalanche in 2020 as a number of high profile acquisitions, fintech startups, and major wealth direct indexing platform launches were announced, increasing adoption by financial advisors and bolstering interest across the industry.
Direct, or personalized indexing is an investing approach that creates a portfolio of individual securities designed to mimic the returns of an index, such as the S&P 500. An index-based mutual fund or ETF typically holds all of the constituent members at the appropriate index weightings to deliver returns that closely track the index return. A direct index portfolio typically includes a subset of the index holdings and will have somewhat higher tracking error or deviation in return to the target index. Whereas an index mutual fund typically delivers single-digit tracking error to its benchmark, a direct index portfolio can exceed 3% tracking error, depending on several implementation considerations. It’s important to note that the deviation is unbiased – the portfolio is as likely to outperform as underperform.
What are the Benefits of Direct Indexing?
Compared to an index mutual fund or ETF, direct index portfolios offer retail investors a number of benefits. By owning the underlying securities directly, the investor has the opportunity to harvest tax losses within the portfolio while continuing to maintain relatively tight tracking error. For example, the S&P 500 includes five airline stocks. A typical direct index portfolio might only include one or two of these stocks given their relatively high risk/return correlation. If an investor developed an embedded loss in one of these positions, the algorithm could harvest the loss and swap to one of the three or four other airline stocks to maintain roughly the same target tracking error to the S&P 500. Additionally, an investor’s unique risk or customization requirements can be factored into portfolio construction, resulting in a better fit with investor’s risk/return tolerance and values.
The explosive growth and adoption of direct indexing is driven by a number of industry developments that have eliminated barriers to adoption, reduced cost, and created the necessary environment for financial advisors and wealth management providers to launch these portfolios.
1) Index Investment Adoption
ETF adoption by financial advisors started in the late 1990s, but accelerated after the 2007-2008 financial crisis. Historically, advisors have favored active asset management and made product and security selection central to their value proposition. In the 2000s, advisors began to transition to financial planning services, focusing on asset allocation rather than product selection. Advisors have increasingly incorporated passive investment products such as index mutual funds and ETFs into their client portfolios—offering individually constructed index portfolios is the next logical step.
2) The Move to $0 Commission Trading
Historically, trading costs and custodial fees presented the largest barriers to direct indexing. Direct index portfolios typically comprise 100 or more holdings, depending on the index (or mix of indices) and the size of the client’s portfolio. Combined with trades for tax loss harvesting, the total volume of trades could result in significant expense to the investor. The move to $0 commission trading by numerous broker dealers1 has significantly reduced or eliminated the trading and custody costs associated with direct index portfolios.
3) Fractional Share Trading & Custody
Traditional brokerage accounts require customers to trade/own whole shares. Within a direct index portfolio, this creates tracking error resulting from rounding of positions to whole share positions (e.g. if the proper weighting of a position is 2.5 shares, the portfolio necessarily would get two or three shares resulting in over- or under-weighting of the position).
A growing number of brokerage and custody platforms are supporting fractional share holdings and trading, allowing for more accurate implementation and tighter tracking error to the target benchmark. When paired with $0 commission trading, fractional share trading allows direct indexing to be implemented cost effectively for much smaller portfolios.
4) New Technologies
Direct index portfolio management requires the use of mathematical optimization and risk modeling software that analyzes and generates trade recommendations based on the unique inputs for each client portfolio. The process also requires the ongoing collection and maintenance of client-specific information, including individual tax rates and realized gains and losses to correctly inform portfolio construction and rebalancing decisions.
Numerous fintech/wealthtech providers have developed new technologies to automate the data collection and financial advice components of direct indexing, along with the portfolio management and trading processes required to support efficient operations across large volumes of individually customized portfolios.
What Does the Future Hold?
These technology innovations and market developments will support massive adoption for direct indexing in the years ahead. Implementation and operating costs have dropped significantly and account minimums have also decreased, to $10,000 on some platforms2 and no account minimums on others.3
2021 is positioned to be a big year for direct indexing as the 2020 M&A transactions result in new direct indexing programs and product launches. Venture and private equity funding and investments from major software vendors and wealth management firms will accelerate what’s already one of the hottest segments in the wealth management industry. Direct indexing provides significant investor value across multiple dimensions, and as advisors become more knowledgeable and comfortable with this approach, I expect we will see rapid adoption and continued growth in market share across the industry.
 Source: https://www.cnbc.com/2019/11/06/as-brokerage-firms-go-to-zero-commission-on-trades-advisors-worry.html
 Source: https://www.businesswire.com/news/home/20191115005451/en/Motif-Launches-the-First-Free-Direct-Indexing-Product-With-10000-Minimum
 Source: https://www.prnewswire.com/news-releases/folio-financial-launches-directindexercom-to-demonstrate-direct-indexing-capabilities-300871364.html