Direct Indexing: What Exactly Is It And Why Are So Many Talking About It?

The term direct indexing is somewhat of a misnomer. After all, as we are regularly reminded by compliance, you can’t invest directly in an index. So what is direct indexing and why has it become so popular?

In its simplest form, direct indexing involves directly investing in the actual securities that make up an index. This is different from investing in exchange-traded funds (ETFs) that track an index or mutual funds that follow a benchmark index. Mutual funds and ETFs are commingled funds: they package underlying securities into a single vehicle that investors can buy but not modify. Everyone who buys that mutual fund or ETF gets the same combination of securities. In other words, one size fits all.

Direct indexing, on the other hand, allows investors to own the securities that make up an index and hold them in a separately managed account (SMA). This gives the investor the same market exposure as the index but also gives them the opportunity to build a customized portfolio. The investor can exclude certain securities or increase their exposure to others to reflect their specific goals, needs, or circumstances.

This type of investing has long been available to high net-worth and institutional investors. However, due to a wave of acquisitions and the launch of proprietary solutions from a variety of asset managers, this product has recently become more widely available to retail clients.

Since most retail investors don’t usually have the funds to buy all of the securities that make up an index, providers of direct indexing products use sampling. Sampling is the practice of reducing the number of securities purchased but keeping the overall portfolio exposures in line to mimic the entire index. This has made direct indexing more accessible to a broader range of investors.

Direct indexing is expected to grow at an annualized rate of more than 12% over the next five years¹, according to a recent report by Cerulli Associates. The report also noted that direct indexing assets claimed nearly one-fifth of the industry’s total retail separate account assets in 2020, reaching $362 billion in assets.

As investors become more sophisticated and knowledgeable, and as their needs become more complex, direct indexing can help advisors offer investors far more options than ever before. Think about your clients: some are more tax-sensitive than others, some have strong environmental, social and governance (ESG) preferences and others don’t, some want to avoid investing in certain industries for specific reasons. Some want to gain extra exposure to certain industries to express their belief in a theme or trend. With direct indexing, meeting those client needs is possible.