Is direct indexing the future?

This article was translated from our sister publication, Conseiller. Read the original in French here.

First, there were passive ETFs. Then came active management, smart beta and liquid alternative products. Where are exchange traded funds headed in the next few years? For two U.S. specialists, the answer is direct indexing.

Speaking at an event in Montreal last week, Matt Hougan, chairman of Inside ETFs, compared the current situation in funds to the evolution of music-listening formats in recent decades.

“You remember when we went from audio cassette tapes to CDs and how we all thought, ‘Oh my god, this is amazing.’ We thought we were going to listen to CDs forever,” he said.

Then came the iPod, and everyone thought carrying 2,000 songs in your pocket was the epitome of choice and convenience, until the streaming services arrived.

“Funds are just a technology,” Hougan said, and they’re still evolving.

Despite their advantages, ETFs are not without shortcomings, said Dave Nadig, managing director of ETF.com, speaking at the same conference. These include:

• more and more products are being created;
• they’re tax efficient, but not optimal;
• they’re governed externally; and
• they don’t take specific investors into account.

For instance, ETF investors can’t model their portfolio on an index while excluding a company they dislike. This what direct indexing can do.

How does it work?

Direct indexing allows investors to directly purchase all or some of the securities in an index based on their specific requirements: their values, their interest (or disinterest) in a particular company or industry, etc.

This can be a relatively complex process and may require significant time and financial resources. This is where advisors can help.

With the declining value of commissions and potential competition from big tech companies, advisors can take advantage of direct indexing to build personalized portfolios for clients, Hougan said.

Nadig said index creators, such as FTSE Russell or MSCI, would be interested in direct indexing, as would BlackRock, Google, Amazon and Facebook.

Technology to the rescue

While the process may seem tedious, technology makes it possible. For example, on the Just Invest platform, clients can answer a series of questions about their interest in investing in various sectors—weapons, oil, human rights, etc.—and can ask to exclude certain specific companies or their employer, whose shares they may already own. The algorithm then rebalances their portfolio based on their answers.

The client’s risk profile is taken into account to make sure it’s in line with the original index, Hougan said, while a multifactor process is also used to make sure the index is followed.

Tax advantages

While potentially costly, custom indexing has a number of tax advantages, including enabling tax‑loss harvesting.

Under certain rules, this technique allows a security that has fallen below its purchase value to be resold and replaced with another. As a result, the capital loss recorded could avoid the tax payable on a potential future capital gain, while staying invested in the market.

While it remains to be seen whether this approach will find favour with investors, Hougan and Nadig see opportunities.