Ten years ago, "liquid alts" were the rage. Investment organisations were hastily hiring staff to support their new creations: mutual funds that emulated hedge funds. Five years later, those same companies were buying or developing robo-advice platforms, which place their users into (allegedly) individualised portfolios. Today’s trend taking the US by storm is direct indexing. Seemingly every major company is on board.

In 2020, Morgan Stanley (MS) bought a direct-indexing provider. One month later, BlackRock (BLK) trumpeted a similar deal, followed the next summer by Vanguard. This February, Fidelity launched its internally developed service, Fidelity Managed FidFolios (fire that naming consultant!). Then came Schwab (SCHW), introducing Schwab Personalized Investing. Great minds think alike. Then again, so do sheep.

(Morningstar (MORN) also announced a direct-indexing deal, acquiring a small European company named Moorgate Benchmarks. I know no more about that deal than what I learned from the press release, meaning just this side of nothing.)

Nuts and bolts

To define the term: With direct indexing, investors own a benchmark’s underlying shares. That is, while index-fund owners possess one investment, those who index directly typically hold dozens or even hundreds of securities, depending upon whether they fully replicate an index, or only sample it. The economic exposure is the same either way: If the benchmark rises by 1% on a given day, so will the portfolios of both the fund investor and the direct indexer.

Holding the stocks directly, as opposed to through a fund, permits personalisation. Following either the investor’s specific orders, such as “sell this security” or “buy more of that one,” or general requirements, such as “avoid companies that sell alcohol,” direct indexers will adjust the portfolio in response to individual needs. (The level of customisation that is allowed varies by the direct-indexing vendor.)

Of course, in these days of fractional shares, investors can assemble huge portfolios on their own. For example, Schwab permits its clients to buy $5 stock “slices,” and Robinhood (HOOD) permits a lower minimum yet. But establishing and maintaining such accounts is tedious. Direct-indexing services greatly simplify the process. Send the money to a single place, along with one’s instructions, and let the professionals do the work.

At least for now, that effort doesn’t come for free. (If direct indexing succeeds, that could change. After all, Fidelity did not expect when opening its first index fund that eventually it would manage a series of such funds, at no charge.) As with many investment services, direct indexing started atop the wealth ladder, offered to private-banking clients at a cost of about 0.30% per year. The newly launched services for Schwab and Fidelity, which require minimum investments of $100,000 and $5,000, respectively, each charge a slightly higher 0.40%.

The second wave

Effectively, direct indexing is the updated version of separately managed accounts (SMA). One generation ago, SMAs were that era’s hot commodity. As with direct indexing, SMAs were modified versions of mutual funds, except the funds were active rather than passive with SMAs. The pitch to investors was that they should not board the mutual fund bus, which was a common ride, but instead relax in a town car that would be all their own.

By and large, separately managed accounts disappointed. SMAs came to market charging a small fortune--an average of 2.05% per year in the early 2000s, according to industry consultant Financial Research. In addition, because technology sharply lagged current standards, the companies that operated SMAs had difficulty processing client requests. In practice, therefore, they discouraged adjustments. Most of an SMA manager’s portfolios looked suspiciously similar.

Direct indexing avoids both problems. For do-it-yourself investors, direct indexing is much cheaper than the early SMAs. Direct indexing through financial advisors is of course pricier because of the second layer of fees, but total annual expenses will still be well below 2%. And the technology has been fixed. Although direct-indexing providers will surely limit their phone conversations--welcome to 2022 product support!--they won’t struggle to execute electronic instructions.

Potential benefits

The question then becomes: Is this additional freedom truly helpful, or is it merely marketing spin?

Using direct indexing for customised investment management is thoroughly and completely spin. Preferring one stock to another is fine, although--as active mutual fund managers have amply demonstrated--such decisions are not profitable on average. But there’s no point in doing so through direct indexing. Instead, buy an index fund to anchor the portfolio, then trade individual equities on the side. Using two investment buckets rather than one is both cheaper and cleaner.

In fairness, while SMAs touted their investment-management possibilities, direct-indexing services are more circumspect. They advertise instead their ability to incorporate user preferences, such as favoring companies with high environmental, social, and governance scores. That is a far easier task. Whereas investors cannot know in advance which stocks will prosper, they can determine which corporate policies they support. That direct-indexing services can implement such choices is an advantage.

So, however, can index funds, which are increasingly tailored for individual tastes. For example, there are now 124 exchange-traded and mutual funds that index while using ESG criteria, 71 of which cost less than Fidelity’s and Schwab’s direct-indexing services. As most investors will accept the ESG selections made by investment professionals rather than conduct their own research, it’s not clear that direct indexing will capture much of the ESG marketplace. Nor will direct indexing necessarily attract those who possess other investment preferences.

Ironically, direct indexing’s strongest opportunity lies with where it started: managing taxes. The technique began in large part as a method by which wealthy investors could lower their tax penalties. Unlike with index funds, directly indexed portfolios can deviate from their benchmarks by selling their losers. Thirty-one days later, by the terms of the wash-sale rule, they may repurchase those same shares. The index position is restored, with a capital loss booked.

Through such a strategy, direct-indexing services can control a portfolio’s tax bill in a fashion that funds cannot. The approach can also be used when divesting from a large and successful stake in company stock. With each capital loss that is harvested, the investor can realize a company stock capital gain of equal amount. Over time, the company stock position will dwindle, making for a better diversified portfolio without generating ongoing tax bills.

In summary, the primary appeal of direct indexing appears to be its relief for taxable accounts, the amount of which will vary according to the investor’s wealth and capital gains status. In a future column, I will estimate the size of that benefit.

John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.