The growth of direct indexing (also referred to as custom indexing, personalized indexing, or an index SMA [separately managed accounts]) is a major development in the investing and wealth management space. Before getting into the details of what it is and how it can be used, I believe it is helpful to review the history of mutual funds and index funds, as well as the major developments that occurred in 2019.
The Invention of Mutual Funds
One hundred years ago, many Americans were investing in the stock market and they relied on brokers to execute their buy and sell orders. The brokers charged commissions, but investors were exposed to other trading costs like the bid-ask spread and unscrupulous market makers (the SEC was not established until 1934). Buying a stock could be an expensive ordeal for individuals, much less buying many stocks to build a diversified portfolio.
In 1924, the first “mutual fund” was launched. Individual investors could now pool their capital in a fund and the fund would buy stocks. Rather than receive shares of stock, investors received shares of the pooled vehicle (they owned the underlying stock mutually, hence the name mutual fund). In a sense, the mutual fund was just a wrapper that held individual stocks. The primary benefit was that investors could purchase a diversified portfolio of stocks with a single purchase.
The Invention of Index Funds
The concept of index investing had been publicly theorized as early as the 1950s. While the mutual fund wrapper was a good vehicle to realize economies of scale for individual investors, some investors were convinced that a lower-cost passively-managed portfolio was superior to a higher-cost actively-managed portfolio. The first index funds were launched in the 1970s and index investing has primarily been delivered to individual investors in a fund wrapper ever since. Rather than buying the individual securities in an index, individuals have overwhelming bought index funds which hold the individual securities in an index. Today, index funds dominate the mutual fund landscape and are nearly synomous with exchange-traded funds (ETFs). The indexing industry’s trade journal and affiliated conference even re-branded from Index Universe to ETF.com and the Inside Indexing conference is now the Index ETFs conference.
Direct Indexing pre-2019
Some index investors have been investing via separately-managed accounts (SMAs) rather than funds, since at least the early 1990s. However, just a handful of firms offered this “direct indexing” service to investment advisors (and individual investors) and minimum investment requirements were relatively high due to high fixed costs. Although minimum investment requirements had declined over the years, even incurring a fee of just $5/trade (multiplied by hundreds of trades per year) limited direct indexing to larger portfolios. Prior to 2019, there were several “robo-advisors” that rolled out direct indexing offerings, but those offerings left a lot to be desired. However, there have been a handful of recent developments and new entrants that have made direct indexing a much more attractive and feasible option for many investors.
What Changed in 2019
In February 2019, the 2019 Inside ETFs conference began with a keynote on “The State of the ETF Union.” Rather than focus on ETFs, the joint keynote speakers (Matt Hougan of Insides ETFs and Dave Nadig of ETF.com) focused on what was coming next. Hougan and Nadig predicted that there would be a “great unwrapping” as investors shifted from index fund investing to direct investing. The presentation centered on JustInvest’s direct indexing solution (Just Invest was acquired by Vanguard in 2021), although it mentioned that Parametric (owned by Eaton Vance at the time, which was acquired by Morgan Stanley in 2021) and Aperio (later acquired by BlackRock in 2020) has large direct index offerings. For the top names in the index fund world to say this was surprisingly to say the least, but their timing could not have been more prescient (as evidenced by all the acquisitions in 2020 and 2021)!
Charles Schwab cut their trading commissions to $0 on October 1, 2019. TD Ameritrade followed suit that afternoon, E-Trade the next day, Fidelity the next week, and Vanguard the following quarter. After a decades-long price war that saw trading fees reduced a dollar or two at a time, every major broker went to zero in an instant. The elimination of trading fees was a long-awaited and welcome development for all investors. It also meant that much smaller accounts could utilize direct indexing and the wave of custodians introducing fractional share trading should reduce the minimum account size even further.
I have a lot of jokes about forecasts and predictions, so I will not offer any here. However, I have observed changes that I expect will continue:
- Direct indexing will be the best choice for many taxable accounts, especially for investors with the highest tax rates. Mutual funds and ETFs will remain appropriate in many situations, but direct indexing will increasingly be the right choice.
- There will be an increase in the number of direct indexing providers and services. I have used several direct indexing solutions and can say that investors need to clearly understand the benefits and drawbacks of each offering. I have seen some great direct indexing offerings, as well as some terrible ones.
- A direct indexing offering will be table stakes for every investment advisor. Advisors have increasingly adopted and recommended direct indexing as trading costs have declined over the years, but there is no excuse to not have a direct indexing option today.