Report examines pros, cons of direct indexing

Qualitative research by Hearts &Wallets is shedding new light on individual-investor reactions to direct indexing in order to inform product and innovation strategies. Direct indexing is considered by some to be the diversified managed investment product structure of the future.

So, what is direct indexing? It is an investing technique that involves buying individual stocks – or exchange-traded funds (ETFs) – that make up an index, in the same weights as the index, explained Laura Varas, CEO and founder of Hearts & Wallets. This is another form of index investing and contrasts with index mutual funds or index exchange-traded funds (index ETFs), which track the index.

Direct indexing tries to replicate an existing stock index, such as the S&P 500 or the Russell 3000, in a taxable account, Varas added.

Through a separately managed account, an investment manager establishes direct ownership of individual stocks, or ETFs, that make up the chosen index. “The direct index allows for tax savings that are not possible with individual stocks through tax loss harvesting and for customization of holdings,” Varas added.

Focus groups conducted

Earlier this year, Hearts & Wallets conducted a series of focus groups in three cities across the U.S. to analyze investor reactions to the direct indexing product concept, in comparison to mutual funds, exchange-traded funds (ETFs) and separately.

Overall, participants in the nationwide focus groups were highly favorable toward the concept of direct indexing, giving it mostly positive grades. In comparison to earlier concept tests, such as “Long-term Retirement Investment” and “Hybrid Active and Passive Fund,” this concept had more positive grades and fewer negative grades, according to Hearts & Wallets.

At a Wealth-Eroding Event in Boston, a female attendee said: “The big word for me was tax efficiency and tax savings. Because I'm sick of getting smoked every day.”

The ability to customize holdings within the index is a potential plus, but the downsides are serious, according to the report.

“Customizing a personalized index can create pride of ownership,” said Varas. “Some people appreciate being able to avoid companies they don’t like. Still, our qualitative research found customization can be complicated, time-consuming, beyond the interests/skills of ‘the average investor,’ and even risky.”

For example, at a Wealth-Building Event in Boston, a male participant said: “I agree. There’s no way if you did not offer the option of hiring managers to do this on my behalf; it's too much work. In other words, my time is worth something.”

Additional findings

The report contains other insights into how to position direct indexing. These include a startling finding that the term “direct indexing” may need to be reconsidered as the name of this technique.

And at least some investors in the focus groups thought that the technique currently called “direct indexing” could be the diversified managed investment product structure of the future.

Who will benefit from direct indexing?

Initially, direct indexing was seen as something for high-net-worth investors because of the tax efficiencies, said Varas, as she explained the types of investors who will benefit the most from direct indexing.

However, she pointed out, lower-asset investors also are expressing interest, as tax optimization has widespread appeal. About 2 out of 3 dollars are in taxable accounts ($45.8 trillion out of $69.7 trillion), in contrast to 1 in 3 dollars being in retirement accounts ($23.8 trillion). Recently, growth has been faster in taxable than it has been in retirement, which is related to increasing concentration of wealth, Varas explained.

Growth in taxable assets has outpaced retirement assets in the past three years (6.7% for taxable vs. 2.2% for retirement). This growth is a reversal of the historical trend of faster growth in retirement accounts vs. taxable.

The managed product of the future?

When asked if direct indexing is the managed product of the future, Varas said that it is really at its beginning stages, but holds much promise.

It’s similar to the advent of ETFs or the use of blockchain to bring down the cost of brokerage accounts.

“It’s really innovative, but time will tell over the next 15 to 20 years about how widely it will be adopted,” Varas said. Hearts & Wallets does think direct indexing could really shake up the product landscape for both asset managers and distributors, Varas added.

“As for right now,” she said, “it’s important for financial-services firms and advisors to educate themselves about direct indexing. The larger firms – Morgan Stanley, Schwab, Fidelity and others – are already launching direct indexing offerings.”

The “Direct Indexing Managed Account” (vs. Traditional Managed Products like Mutual Funds, ETFs, SMAs): How to Engage Consumers in the Managed Account Structure of the Future report is drawn from Explore Qualitative Database, which supports firm initiatives to foresee how unmet needs may change the competitive landscape. The report is the first of six from the Explore Qualitative 2023: Money Movement & Strategic Industry Dynamics series.

The Explore 2023 nationwide focus groups were held in Los Angeles, Minneapolis, and Boston in the spring. All 72 participants were actively involved in money movement, either having recently concluded a transaction or considering one in the next 12 months. The groups included participants ages 35 to 64 with sole or shared responsibility for investment decisions and over $250,000 in investable assets (excluding the primary residence) and over $50,000 outside their workplace retirement.

Ayo Mseka has more than 30 years of experience reporting on the financial services industry. She formerly served as editor-in-chief of NAIFA’s Advisor Today magazine. Contact her at [email protected]. 

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