Heralded as the next big wave of technology-powered innovation in the investing space, direct indexing is positioned as a newly accessible “must-have” personalized investing approach once reserved for only the wealthy. Cerulli projects that assets in direct indexing products will grow to $730.5 billion by 2026.
The projections suggest investors have a massive appetite for direct indexing because it offers investment personalization that ETFs and other prepackaged investment products can’t. Direct indexing allows investors to replicate an index by selecting and buying an index’s components. It offers the option to include or exclude specific securities. In theory, investors can better prioritize personal values and generate tax alpha through tax-loss harvesting, i.e., using the losses of individual securities to offset the gains of other securities.
And yet, are investors demanding to own a fully customized list of hundreds of stocks? Or has direct indexing remarketed itself around broader investor interests to find demand?
Direct indexing was initially designed to maximize the benefits of tax-loss harvesting, which is its most appealing benefit by an overwhelming margin. Eighty-seven percent of industry executives rank tax optimization as the most popular benefit of direct indexing, according to Cerulli Associates’ research report: U.S. Managed Accounts 2021: The Evolution of Personalized Investing.
However, the real-life benefits of tax-loss harvesting may not be entirely everything marketers claim. More importantly, investors aren’t asking for theoretical tax alpha as a primary goal from an investment product.
Instead, 80% of investors aged 40+ are asking to align their investment portfolios with their values, according to research from New York Life Investments. That number goes up to over 90% of investors between 24 and 39. Investors are becoming far more interested in better understanding what their money is doing in the world and taking back control. As a result, global ESG assets will exceed $53 trillion by 2025, representing more than a third of the $140.5 trillion projected total assets under management (AUM), according to Bloomberg.
Amid this massive uptick in demand for more values-aligned portfolios, providers of direct indexing have morphed their marketing efforts around allowing investors to screen companies out of an index based on values. Ironically, screening out companies based on values from a preexisting index consisting of hundreds of stocks limits the benefits of tax-loss harvesting and deviates from the index’s performance. Using a light values screen, an advisor may present a greenwashed, “values-based” portfolio that doesn’t bring values to life. Too heavy of a screen, the advisor may offer an allocation that significantly deviates from the index. When you’ve sold an investment product based on the idea of tracking an index, you’ve created a paradox; too much deviation subverts the purported benefits of direct indexing.
Meanwhile, direct indexing marketers often fail to acknowledge the operational, reporting and compliance issues of trying to implement portfolios that own hundreds of different stocks for every client.
Here’s the reality: Investors aren’t asking for their customized version of the Russell 2000. They aren’t asking to track or be beholden to an index. They are not asking for specific product solutions, like indexed ETFs, mutual funds, direct indexing or boutique SMAs with thematic approaches. None of it.
Instead, investors want a better experience, one where a financial advisor shows a willingness and ability to more deeply understand them and what they want to accomplish with their money beyond financial goals.
By positioning direct indexing and its supposed benefits as the solution to values-aligned investing, advisors prioritize selling a product over listening to their clients.
Advisors and investors win when the advisor starts by uncovering what matters most to their clients and makes the product options secondary. By understanding clients more holistically than a one-time screening exercise, advisors actually can address what clients want.
Zachary Conway is the founder and CEO of NYC-based Seeds Investor, a software platform for financial advisors to assess and understand investors’ values and needs and automatically deliver customized portfolios.