Direct Indexing Minor Threat To ETFs

Direct indexing has benefits for many, but won’t be the right solution for everyone.

Much has been made of direct indexing over the last few years, with many heralding it as a direct competitor to ETFs.

While some assets that will have otherwise gone into ETFs might go the direct indexing route instead, these options should be viewed as two tools in a toolbox. Rather than being in competition for the same assets, investors should decide whether direct indexing or ETFs is best for their individual situation and needs.

What Is Direct Indexing?

Direct indexing involves purchasing the underlying securities that make up an index rather than buying a pooled investment vehicle like the SPDR S&P 500 ETF Trust (SPY). The benefit of buying the securities individually is twofold. It offers a higher degree of customization and allows for the generation of "tax alpha" by allowing individual securities to be sold at a loss. Tax alpha refers to the ability to achieve additional return on your investments through tax minimizing strategies.

For example, consider an investor who works at Apple and receives Apple stock as part of her compensation package. Her overall assets and financial well-being is heavily tied to the stock performance of Apple.

To reduce risk, she might not want her large cap portfolio to have exposure to this stock.

Chart courtesy of FactSet

By buying an ETF like SPY, she would be unable to avoid having an additional allocation to Apple stock. However, direct indexing would allow her to build an S&P 500 allocation without Apple stock.

Customization Has Many Uses

This customization has many practical uses. Along with being able to avoid specific stock for reasons such as those listed above, direct indexing is also compelling for an environmental, social and governance (ESG) perspective.

Many ESG investors want to align their portfolio with their values, but ETFs such as the iShares ESG Aware MSCI USA ETF (ESGU) have broad ESG mandates that won’t necessarily align with everyone’s philosophy. (Read: What ESG Investing Is Meant To Be)

Direct indexing would allow for true customization, screening out specific stocks or entire industries and sectors. Investors could also tilt the portfolio toward companies that have high ESG ratings or other desirable characteristics.

As an example, ESGU maintains an energy allocation that is nearly identical to that of SPY, including ESG-risk-laden names Exxon and Chevron. In fact, Sustainalytics gives Chevron a “severe” ESG risk rating.
 

Chart courtesy of FactSet

An investor might use direct indexing to screen out all companies that are affiliated with fossil fuels or any other factor that does not align with their values.

When An ETF Might Be Better

As is almost always the case, this higher level of customization comes at a cost. The management fee for direct indexing could cost as much as 0.30% or higher. Compare this to SPY, which has an expense ratio of 0.09%, or ESGU which rings up at 0.15%.

And while the tax alpha generated might make up for the expense ratio, strong up-markets where most securities have appreciated over the tax year minimize the opportunity to harvest enough losses to offset gains within the portfolio.

Higher levels of customization also mean a higher level of tracking error. This tracking error might mean that the customization adds alpha over the broad index, but it could just as likely result in underperformance. Those who opt for direct indexing will need to find the balance between customization and tracking error.

(Use our stock finder tool to find an ETF’s allocation to a certain stock.)

Looking Ahead
Cerulli Associates is forecasting that direct indexing will grow at an annual rate of over 12% during the next five years, outpacing the projected growth for ETFs and other investment vehicles.

An important consideration when analyzing these growth rates is the total level of assets. According to Cerulli’s data, direct indexing had $362 billion in assets at the end of last year. This means projected growth for 2021 is $45 billion.

Compare this to the $5.5 trillion ETFs had at the end of December with an 11.3% growth rate, suggesting the vehicle could grow by $617 billion this year. In fact, total ETF assets under management are already nearly 25% higher from the beginning of the year.

Issuers seem to be betting that direct indexing will continue to gather assets. Last November, BlackRock announced the purchase of direct indexing firm Aperio Group. In July, Vanguard entered into a definitive agreement to acquire Just Invest.

Index providers are also getting in on the action. Last month, Indxx announced a partnership with C8 that would provide customizable access to seven of their index strategies.

While many in the ETF ecosystem are preparing for the growth of this type of investment, ETFs still have strengths that will make them a popular choice for many investors in the years to come.

Contact Jessica Ferringer at [email protected] or follow her on Twitter