Given that investment trusts have been around since the 19th century and mutual funds for the best part of 100 years, there’s little wonder that the fund management industry can be viewed as a bit archaic.
Perhaps that’s unfair, as the dawn of passive investing has led to a proliferation of exchange traded funds, but even ETFs have been around since the early 1990s.
However, an interesting development is gathering pace in the US which may force asset managers to move away from these off-the-shelf investment products. Several of the big asset management firms have been buying up companies that specialise in ‘direct indexing’, where investors can buy the stocks of an index directly, while customising to include sustainability preferences or tax efficiencies, instead of purchasing a mutual fund or ETF.
While ultra high net worth investors have invested via this strategy for years, new algorithm-based platforms are making it available at very low costs – potentially not much more than the cost of owning an ETF and significantly cheaper than active funds. Historically, the strategy helped investors reduce their tax bill via a process known as “tax-loss harvesting” where investors can systematically sell losing stocks and replace them with similar holdings, to offset any gains achieved elsewhere.
Magnus Burkl, a principal at consultancy Oliver Wyman says direct indexing “now has the potential of becoming a mass retail product” in the US, and he expects the strategy to grow at a rapid rate in the UK and Europe in the next two to five years.
Burkl identifies several reasons for the growing demand for personalised index portfolios. He says the most important is that it gives investors a chance to add their own preferences to a portfolio. This might include personal environmental, social and governance (ESG) preferences, or any other specific risk or factor exposure you might want to build in.
For example, if you work for a listed company included in an index, you might want to remove it from your investment portfolio as your salary is already dependent on that firm.
You can also build in factor exposure – where you might want to overweight a certain country where you think stocks are undervalued, or build in a preference for small cap companies.
In the US, Vanguard, JPMorgan, BlackRock and Morgan Stanley have all done deals in 2021 to bolster their offerings in direct indexing. Vanguard’s deal to buy bespoke portfolio-maker JustInvest was the company’s first acquisition in its 46-year history.
Franklin Templeton joined the party last week, announcing plans to buy O’Shaughnessy Asset Management, which has a custom indexing business called Canvas, with $1.8 billion in assets.
Hector McNeil, co-CEO and founder at HANetf says he thinks we are still “some way away” from mass adoption of direct indexing in the UK, and he cautions that interest in direct indexing is coming from advisors who traditionally put their clients into mutual funds, providing a way for them to earn fees which they would not if they put their clients into ETFs.
But it’s clearly something the world’s largest money managers are investing in. Watch this space.
