Direct indexing is primed to grow at an annualized rate of more than 12% over the next five years, faster than traditional financial products, such as mutual funds, exchange-traded funds (ETFs), and separate accounts, according to Improving Client Experience: Customizing with Direct Indexing, a new report from Cerulli Associates and sponsored by Parametric Portfolio Associates. Providing the industry’s first codified definition for direct indexing, the report describes how a variety of industry trends are creating demand for the customization benefits of direct indexing beyond tax optimization.

Leading direct indexing solutions are customized separately managed accounts (SMAs) that provide investors direct ownership of individual securities in an index-like solution. The primary objective is beta exposure that can be customized and improve outcomes by leveraging tax efficiencies, environmental, social, and governance (ESG), factor tilts, and thematic investing. Unlike mutual funds or ETFs, direct indexing provides individual portfolios with greater control to harvest gains and losses at the individual security level, while staying in risk and tracking error bands.

“Direct indexing’s most quantifiable value is tax optimization and the resultant tax savings. Advisors can scale direct investing across customized taxable accounts to provide pre-tax performance, offset expected and unexpected capital gains, streamline rebalancing, and provide flexible funding options,” according to Tom O’Shea, director at Cerulli. “Leading advisors view the tax optimization as a unique and tangible value they can deliver, but the solution offers additional customizations—responsible investing, flexible onboarding, and tax-optimized charitable giving—which can help advisors further differentiate their services.”

Direct indexing assets claimed nearly one-fifth of the industry’s total retail separate account assets in 2020, totaling $362 billion in assets. Despite its advantages, direct indexing remains a niche product and is used by a small group of advisors for high-net-worth clients. That said, industry momentum is building and the market for the product is broadening—asset managers are acquiring direct indexing providers, introducing proprietary solutions to market, and applying direct indexing to new asset classes.

“Even a modest increase in adoption among this segment can drive assets higher. Our findings suggests that direct indexing will help wealth managers achieve a more robust service offering, fulfilling unique portfolio customization requirements from investors across the wealth spectrum,” adds O’Shea.

“More and more investors and their advisors are recognizing the value—the tax advantages, the flexibility, the ability to tailor to client mandates—that these SMAs offer. As a result, M&A activity has bolstered asset management firms’ offerings in this category—so much so that these solutions have drawn a new label: direct indexing. While the name may be new, the value and appeal of this approach is not. In fact, it’s one Parametric pioneered in the early 1990s,” comments Brian Langstraat, CEO of Parametric.