Technology providers require direct indexing in mass flow

Investment firms are vying to provide access to direct indexation (DI), a way to create individual indexes for individual clients, as demand for portfolios that are more personalized and tax-efficient increases.

Previously, DI was limited to wealthy clients and their wealth managers due to higher costs. But recent developments in technology have brought adaptive indexes to a wider customer base. Companies are rushing, acquiring new fintech partners and building their DI proposals.

“There’s a bit of a race right now,” said Daniel Needham, president of Morningstar’s wealth department. The index group bought direct indexing specialist Moorgate Benchmarks in September, following in the footsteps of other industry titans such as Vanguard, BlackRock and Morgan Stanley.

DI allows investors to adjust their portfolios according to their specific investment interests, choosing to include or exclude specific stocks, as well as to weigh the units according to their preferences. For example, they can define environmental, social and managerial (ESG) powers – or strategies for investing value or momentum.

But the demand for DI is also driven by its use as a tax instrument. In the US, DI can provide tax breaks because it allows investors to reduce their tax liabilities by collecting tax losses: selling shares that lose value and matching the loss to profits to reduce the capital gains tax due on other investments .

“There will be an increase in demand for these services. . . The ability to customize a portfolio to scale for a person is quite fascinating – especially when people are beginning to express their personal values ​​in their portfolios, ”says Needham.

About 20% of retail investors’ accounts are held in DI products, according to a study by Cerulli Associates. And the market share occupied by personalized products is expected to grow, with estimates suggesting that they will account for more than 8% of all assets under management by 2030.

As a result, there has been a seizure of land among the great traditional managers to find partners who can help provide solutions for direct indexing of customers.

BlackRock acquired Aperio in November 2020, while JP Asset Management took over OpenInvest in June 2021 to provide more personalized ESG offerings. Vanguard made its first acquisition in its history when it purchased Just Invest in July 2021, a wealth management boutique that offers DI customization.

DI-managed assets have grown rapidly in recent years, according to a Morgan Stanley study. In 2020, about $ 3.5 billion was managed through DI. This figure is expected to grow by an average of 34% per year over the next five years to $ 1.5 trillion from the demand for wealth managers alone.

A 2022 study by the CFA Institute found that DI is the most popular personalization tool for investors who have financial advisors, with 56% saying they are interested in using them.

And customization is in high demand. Eighty-two percent of respondents said they were interested in increasing the personalization of their investment products.

DI is especially valuable in high value portfolios invested in alternative solutions such as hedge funds, private equity and less liquid alternatives.

“In each of these cases, if the main goal is to provide alpha or higher productivity, end-of-day tax is not the main consideration,” said Stephanie Pierce, chief executive of investment firm Dreyfus Mellon and listed traders. funds in BNY Mellon Investment Management. Investment losses can also be carried over from one year to the next to offset profits.

“If you know you’re going to have potential capital gains, it’s good to have something that works for you all year long that is designed to give you the same return as the market, but also gives you tax compensation at the portfolio level,” he added. she.

But DIY stores are also intervening as retail brokers compete to offer solutions to investors. In April, America’s largest retailer, Charles Schwab, launched a DI product for customers as part of a tax management proposal. The broker builds his own DI solution instead of partnering with a supplier. Another U.S. brokerage firm, Fidelity, added 12,000 new jobs this year, said as part of efforts to expand into new areas such as DI.

Interest in DI has been catalyzed by recent market launch. “We’ve been through a decade-long bullish stock market, so you have a large number of individuals who have made investments over time and can hold funds that have made significant profits,” said David Botsett, head of capital project management at Charles. Schwab. “They can see the potential impact that taxes will have, and that makes them increasingly look for opportunities for tax benefits in their accounts.”

In a fragmented or falling market, investment losses create more opportunities to offset these large gains.

The abolition of trading commissions has also helped make DI possible for more investors than just individuals with extremely high net worth, Botset added.

“The industry, which has historically focused on pre-tax returns, has begun to focus on: what these taxes mean and the consequences,” said Liz Michaels, co-head of longtime Aperio, which was acquired by BlackRock in February.

But despite the noise around supply, advisers say DI is not for everyone.

“This is the new thing, but it doesn’t mean that the old – exchange traded funds – are not the right answer for many people,” says Michaels. “Collecting tax losses only makes sense if you have capital gains elsewhere in your portfolio. It’s an extremely powerful tool for people who need it, but it’s more complex than people realize. ”

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