Asset managers prepare for investor shift to bespoke equity portfolios

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The biggest names in asset management are preparing for a major shift to an era in which investors demand customized equity portfolios that have traditionally been the preserve of wealthier clients.

U.S giants like The Vanguard Group Inc., JPMorgan Chase & Co., BlackRock Inc. and Morgan Stanley have all done deals since 2020 to bolster their offerings in so-called direct indexing – a more bespoke approach to off-the-shelf investment products. Fund managers expect this will mark the next stage in the democratization of finance and will probably put pressure on traditional products such as mutual funds and exchange-traded products.

By the middle of this decade, direct indexing is forecast to account for US$1.5-trillion of global assets, up from less than US$500-billionn now, “by taking share from other passive products such as mutual funds and [exchange-traded funds],” according to a recent report from Morgan Stanley and consulting firm Oliver Wyman.

Direct indexing represents a “do-it-yourself arms race among wealth managers,” Neil Sheehan, an analyst at Cutter Associates, wrote in a recent report earlier this year when he was at Celent.

“While the growth of ETFs will not be stopped by the rising popularity of direct indexing, wealth and asset managers will face disruption in how advisors expect products to be constructed and distributed,” he added.

Direct indexing allows investors to own a group of stocks that mimic the performance of an established index, and to customize the portfolio to manage tax losses or to include environmental, social, and governance preferences. While this has long been a service available to wealthy investors, new technology is now making personalized portfolios possible for a broader audience.

With direct indexing, “a financial advisor via a computer can easily tailor a portfolio that mimics an index, like the S&P 500, while including specific tilts such as ESG, rebalancing between winners and losers and also reducing tax exposure,” says Tom O’Shea, research director at Cerulli Associates.

“In time, say over the next 10 years, more people will walk into an advisor’s office and get a customized portfolio of securities,” he adds.

Unlike an equity mutual fund or an ETF, in a direct indexing portfolio, the investor owns the securities in their account rather than a share of a pooled fund. Sophisticated computer software ensures the portfolio tweaks weightings in order to replicate the performance of the index, and to customize holdings toward investment factors such as growth and value stocks or other preferences.

U.S. fund manager Parametric Portfolio Associates LLC has dominated the sector since it first created a customized separately managed account, or SMA, that behaved like an index-tracker on behalf of a family office in 1992. It has since developed a direct indexing business that oversees close to US$250-billion across 110,000 individual SMAs.

“Direct indexing gives a freedom to capture a broad swath of the market that can then be overlaid with ESG’s or factors or tax considerations,” says Brian Langstraat, chief executive officer of Parametric.

Other asset managers with vast mutual and ETF offerings are positioning themselves for a future in which these products could face stiff competition from custom portfolios.

As part of investment group Eaton Vance Corp., Parametric was acquired by investment bank Morgan Stanley last year in a deal that kickstarted a flurry of activity.

BlackRock bought Aperio Group LLC, the second-largest player in direct indexing after Parametric, in November. Vanguard made its first acquisition in its 46-year history in July, buying Just Invest LLC, an Oakland, Calif.-based wealth management boutique that provides a customizable, direct indexing service, and was founded in 2016.

In June, JPMorgan Asset Management acquired OpenInvest, a fintech platform that facilitates the customization of a portfolio based on ESG metrics. This month, BlackRock bought a minority stake in SpiderRock Advisors LLC, an options service for SMAs.

While disruption from direct indexing looms, many do not see demand for low-cost ETFs and mutual funds fading any time soon.

“The desire to personalize is real,” says Martin Small, head of the U.S. wealth advisory business at BlackRock. But he believes that rising demand from investors seeking advisory services will maintain growth across ETFs, SMAs, mutual funds, and other products.

“Owning low-cost ETFs and basic mutual funds is the best way to grow tax-deferred returns over time for most investors,” he says.

The prospect of governments implementing higher taxes on trading profits in the future – particularly in the U.S. and Europe – could provide a further boost to SMAs and direct indexing.

Owning shares in companies directly rather than holding those issued by an equity ETF or a mutual fund, facilitates what is called tax-loss harvesting, whereby direct indexers systematically sell losing stocks and replace them with similar holdings. That allows investors to offset capital gains taxes incurred when their investments are up, and stay in line with the index they are following.

Tax-loss harvesting capabilities are estimated to add 0.5 per cent to 1 per cent of annual post-liquidation return after taxes, according to Canvas, a direct indexing firm with US$1.7-billion in assets.

“Tax gets a lot of people in the door and then once they are on the platform, they see how it becomes a one-stop-shop for investors and advisors,” says Patrick O’Shaughnessy, CEO of O’Shaughnessy Asset Management LLC, which owns Canvas.

“Technology is enabling a lot of this. A broader awareness of direct indexing means that if it becomes a thing, it will be huge,” he adds.

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