Direct Indexing May Not Be the ‘ETF Killer’ Everyone Thinks

Direct indexing is expected to go toe-to-toe with the ETF industry in the coming years, but recent research is questioning just how serious that threat will actually become. 

The strategy has opened up new personalized indexes to investors, but it’s also a niche service that mostly benefits specific high-net-worth investors, according to a study by the asset management research firm Blackwater Search & Advisory. Without benefiting a broad range of investors, the popularity and growth of direct indexing may be significantly muted.  

While asset managers have long feared the fast-growing direct indexing marketplace, those fears may have been overblown. 

“Direct indexing is not necessarily the best option for everyone,” according to the report. “Not everyone needs or wants the degree of customization that direct indexing offers, and the variety of funds already existing on the market is more than enough to craft interesting portfolios.”  

ETFs, on the other hand, offer a wide range of cheap funds with low trading costs, and most importantly, can benefit a large swath of the investing public in the U.S. Abroad, fewer than one in five European ETF firms say they expect to develop a direct indexing option for clients, the report found.  

Still, the strategy has been called an “ETF killer” because it allows investors to directly buy equities and build customizable portfolios. It also offers greater personalization, and tax advantages than buying mutual funds or ETFs, by letting investors passively invest in the market, but throw away the fund wrapper. 

A separate report from Cerulli Associates estimates direct indexing will come to represent one-third of retail separate accounts by 2026, driven by affluent clients with $2 million to $3 million in assets—a significant and sought after portion of the investable assets in the U.S. 

Just last month, Morningstar Inc. stepped into the fast-growing direct indexing market, following Fidelity Investments and other money managers. While direct indexing is projected to take on market share in the coming years, what impacts it will have on the etf industry are still far from clear. 

The threat was real enough for top assets managers, like Morgan Stanley, BlackRock Inc. and Vanguard Group Inc., to acquire small direct indexing firms in recent years and offer the services to their clients.  

“While the small size of the direct indexing market makes the threat appear limited so far, it looks like asset managers are taking it seriously as they bought the biggest direct indexing providers and positioned themselves to reap their revenue,” according to the report. 

With some direct indexing offers start with as low as $1 initial investment, the Blackwater report stressed the need for investors to be aware of all of their possible options and the associated risks.  

“All in all, direct indexing is an interesting but niche service right now,” according to the report. “Will it remain so? Only time will tell.”