By Hillary Keitel, Head of US Wealth, Information Services Division, London Stock Exchange Group
Among the many reasons Schwab Impact is a must attend event each year is the chance to hear where the industry is going. This year, the buzz was definitely around direct indexing and customization. The term "direct indexing" is essentially a new spin on Separately Managed Accounts – a tried and true investment structure. The change in nomenclature reflects that, thanks to new technology, what was once available for just the largest institutional investors can now be delivered efficiently and effectively to relativity small retail investors.
RIAs and wealth advisors are well positioned to utilize direct indexing to help their clients reach their personal life goals. So, it’s no surprise that it was a popular topic at Impact. Fractional share trading and zero fee commissions are accelerating this trend that enables access, personalization, and thus democratization of investments.
Direct indexing is generally executed using the Unified Managed Account (UMA) structure, which allows an investor to hold ETFs, mutual funds, individual securities and SMA strategies all in a single account. The implementation of a UMA is executed by an overlay or investment manager whose sole purpose is to execute trades. Overlay managers can then license an index to be directly and fully replicated in investor portfolios – thus “direct” indexing.
But index providers like FTSE Russell play a much bigger role than just licensing. We provide high-quality market data and construct transparent, representative, and replicable indexes based on a range of investment requirements such as liquidity, tracking error, portfolio turnover and risk budget.
This means that our clients – including investment advisors and wealth managers – can use our indexes as a means to invest directly in a customized basket of securities. As our Rolf Agather, managing director of North America research, wrote previously, this approach provides investors with key benefits, including:
- Tax advantaged. Investors may implement tax loss harvesting on individual stock positions.
- Customizable. Investors may exclude investments due to concentrated, single-stock positions or avoid investing in certain ESG areas.
- Holdings transparency. Account statements show individual securities owned and the number of shares/bonds of each security owned.
- Fractional shares. Direct indexing also allows for fractional share trading, which can lead to investor benefits such as lower account minimums, minimal tracking error and easier portfolio deposits, withdrawals and rebalancing.
Let’s consider a simple example. A socially conscious investor wants to invest in line with her values. Certainly, she can select a fund solution that seeks to track a benchmark that measures the investment return of large-, mid-, and small-capitalization stocks of companies and is screened for certain environmental, social and corporate governance criteria. But perhaps she is already heavily invested in some of the FAANG stocks, which are among its top holdings. Or perhaps she would like to place greater emphasis on particular issues important to her, such as human trafficking or diversity. Her overlay manager now has the ability to precisely define a customized basket of securities that expresses her view in a low cost, transparent and tax advantage portfolio.
Direct indexing is a compelling option so it’s no surprise this innovation is generating buzz as the next big thing. However, FTSE Russell believes that direct indexing will be a complement, not a competitor, to other index-based approaches, especially ETFs. The core value proposition for ETFs remains highly attractive for the vast majority of retail investors. But for investors seeking greater customization or with a need for additional tax management, direct indexing is worth considering.
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