Why asset managers are buying direct indexing firms.
In the last year or so, we’ve seen a slew of acquisitions of sub-advisory firms, mostly direct index managers. Franklin Templeton bought OSAM Canvas, Vanguard bought Just Invest (link), JP Morgan bought OpenInvest (link) and 55ip1 (link), Morgan Stanley bought the parent company of Parametric (link), Schwab purchased the assets of Motif Investing (link), and BlackRock bought Aperio (link).
These acquisitions have put a spotlight on direct indexing (a direct index is like an index ETF, but where the investor directly owns some or all of the securities in the index2). Why all this activity?
The short version is that direct indexes are more customizable and more tax efficient than ETFs, and investors have noticed. Schwab CEO Walt Bettinger stated recently that “personalized investing is coming at all of us like a freight train” (link). Here’s what BlackRock had to say explaining its acquisition of Aperio:
“The wealth manager’s portfolio of the future will be powered by the twin engines of better after-tax performance and hyper-personalization…{We} will bring institutional quality, personalized portfolios to ultra-high net worth advisors and will create one of the most compelling client opportunities in the investment management industry today.” (link)
And here’s what RIABiz had to say about Morgan Stanley buying Eaton Vance:
“Morgan Stanley's Eaton Vance deal yields a golden nugget — Parametric — and a means to own the direct-indexing super trend.” (link)
The “direct-indexing super trend” in the above quote presumably refers to the growing demand for direct indexes. Parametric and Aperio have grown at roughly 20% per year for more than a decade.
With all this as a preamble, let’s take a closer look at what makes direct indexes so attractive (you can also see this video from our parent company, Smartleaf).
The Advantages of Direct Indexes
There are three main advantages to direct indexes: tax efficiency, risk customization and ESG customization.
We see the market for wealth management services moving away from a “beat the benchmark” value proposition. In its place, investors will demand more value, which includes tax management, risk customization and impact investing.
The Technological Advances Behind Mass Market Direct Indexes
There’s a back-to-the-future quality to direct indexes. Owning baskets of stocks long predates the invention of the mutual fund or the ETF. Direct indexes themselves have existed for decades. What’s new is that while direct indexes used to make sense only for ultra wealthy investors, they're now affordable and practical for ordinary investors. That is, what’s new isn’t the concept of direct indexes. It’s that they can now be offered at a price point that makes them a superior alternative to ETFs for most investors. The technological innovations that have made this possible include:
At heart, the case for direct indexes is simple: higher after-tax expected returns and more customization. That answers the question of why. But it still leaves open the question of how. How do wealth managers go about incorporating direct indexes into their day-to-day operations? We’ll take up this issue in our next post.
SAM and direct indexes
SAM manages direct index portfolios for wealth managers. SAM offers both direct index separately managed accounts (SMAs) and unified managed accounts (UMAs) with direct index cores. With UMAs, the client wealth advisory firm retains control of asset allocation and product choice — including the option to subscribe to third-party asset allocation models. (SAM recently announced that it includes in its base offering asset allocations and direct index portfolios tied to Morningstar indexes.)
155IP is not currently a direct-index provider, but it does focus on tax management.
2The term “direct index” is sometimes used to refer more generally to the idea of unbundling or “unwrapping” mutual funds and ETFs, regardless of whether the strategy is literally following an index. In this sense, “direct index” basically means the same thing as a separately managed account (SMA), though perhaps less tethered to the specific implementation structure typically associated with SMAs.
3Important disclosures: The results of the study are not the actual results of any account. The results will vary considerably for any given account, depending on many factors, such as the investment strategy, the number and size of the existing equity holdings, the age of tax lots, the applicable marginal tax rate and many other factors. The results of this study should not be regarded as a prediction of the benefits of pursuing a tax-sensitive transition through direct investment vs. liquidation and the purchase of an ETF. For the purposes of the study, every investor was assumed to have tax rates of 20% on long term gains and 40% on short term gains, and trading costs were ignored. A liquidation/ETF transition results in a tracking error of close to zero. In contrast, the accounts that were transitioned to a direct index in a tax sensitive manner had an average tracking error of 1.54%. Therefore, a critical component of effective tax management is consideration of the trade-off between tax efficiency and fidelity to the target index.