The level of assets funneled into direct indexing is expected to grow 12.3% annually, hitting $825 billion in total assets by the end of 2026, according to a Cerulli Associates report.
This growth will surpass that of ETFs, mutual funds, and the overall separate account market, the report said, though the low level of total assets in direct indexing today ($462 billion) means it will stay in fourth place by market share, even in 2026.
And not all of the growth will be coming from new money coming into the industry—investment in mutual funds is expected to decline 2%, while EFTs and SMAs will grow more modestly at 9.5% and 7.25, respectively.
Tom O’Shea, research director of managed accounts for Boston-based Cerulli, said he wasn’t surprised by the predicted double-digit growth of direct indexing because of the level of supply entering the market.
“From large brokerage firms like Morgan Stanley and its acquisition of Eaton Vance, which got them Parametric, to asset management firms, like BlackRock buying Aperio, to a whole slew of other acquisitions on the fintech side as well as the asset management side—firms are driving more assets into the financial services industry,” he said. “And I think it comes off the success Parametric has had. It’s been a quiet success that no one’s really been aware of because it’s been mostly successful in the registered investment advisory community, as opposed to the wirehouse or regional broker-dealer community. And mostly among high-net-worth advisors.”
Parametric was one of the first firms to offer customized portfolios monitored by computer algorithms for tax efficiency and investment strategy. It was acquired by Eaton Vance in 2003, and Eaton Vance was acquired by Morgan Stanley in 2021.
With an eye on cornering some of that success for themselves, 75% of managed account sponsors told Cerulli that direct indexing was the top product they wanted to add to their services for affluent and high-net-worth clients. According to the report, the trend has been spurred by the fact that most advisors are now looking at client assets holistically through fee-based financial planning and the lens of a fiduciary.
With “fee-based” no longer a differentiator, direct-indexing capabilities are the next great attribute to trumpet, the report said. Direct indexing, where the client holds the individual stocks usually that make up an index, provides significant opportunities for tax-loss harvesting on a more frequent basis than annually, the ability to customize the portfolio for client values, ESG or any other filter, and unwinding concentrated stock positions, the report said.
“Two of those, the tax-related benefits, land squarely with the mass affluent and high-net-worth demographic. With them, you start to see more assets held outside an IRA, you start to see executives inheriting concentrated positions or getting their own position through their company and they need to diversify,” O’Shea said. “Unwinding that could generate a huge tax burden that can be mitigated by direct indexing.”
These clients also may find themselves in a higher tax bracket, and direct indexing offers more of an opportunity to generate a better after-tax return, he said.
“When you ask advisors, ‘Do you manage for taxes?’ they say, ‘Yeah, I manage for taxes,’ but that sometimes just means they look at losses in November and sell a bunch of them,” O’Shea said. “But that isn’t as effective as an algorithmic process that’s sitting there looking for tax losses all the time at a rate that people just can’t keep up with.”
One hurdle that has kept more advisors from embracing direct indexing has been the cost, but there had been so many consolidations and new entrants in the field in the last year that the cost is dropping.
And last fall, at the Schwab Impact 2022 conference, Walter Bettinger, CEO, announced that finding the lowest fee possible is now a priority for Schwab.
“We have to get that cost down closer to where a regular ETF or an indexed mutual fund might be,” Bettinger said to some 5,000 attendees last November. “We’re going to disrupt that industry, and it’s going to help you serve more clients.”
Changes within direct indexing programs themselves are showing how quickly this piece of the industry is developing, the report said. Offering fractional shares is one of those changes, and so is building out the asset classes that can be directly indexed. Direct indexing started with large-cap U.S. equities, but quickly moved to international, small-cap, and now even fixed income in some cases, though O’Shea was quick to point out that “direct indexing” is a bit of a misnomer.
“The term we’ve been trying to promote is personalized separately managed accounts, or personalized SMAs, and that’s because once you get into the fixed-income world, you’re not going to mimicking an index,” he said. “What you’re doing is setting up a bond ladder with some ability to generate a better after-tax return. But there’s no index involved.”
Despite some providers moving down-market (last year, Fidelity started offering direct indexing with a $5,000 minimum and Altruist did the same with a $2,000 minimum), Cerulli said it expects the biggest growth to come from financial advisors bringing direct indexing to high-net-worth and “mass-affluent” clients for the first time.
Prior Cerulli surveys have shown that only 14% of financial advisors recommend direct indexing to their clients, despite 63% of financial advisors serving clients with a core market of more than $500,000 in investable assets, and 14% targeting a core market of more than $5 million, the report said.
“Simply put, many financial advisors with clients who are best suited for direct indexing are not using these strategies in their practices,” the report concluded.