Direct indexing has surged in popularity recently. Cerulli Associates projects that growth in the space will outpace that of mutual funds, ETFs and other types of separately managed accounts over the next several years. This offers investors the benefit of more choices, however direct indexing strategies present unique evaluation challenges relative to other types of vehicles and investment strategies.

Direct indexing strategies are passive investment strategies with a tax-benefit advantage. Designed to track index returns on a pre-tax basis, these strategies also seek to deliver better after-tax returns through proactive tax loss harvesting. The most common strategies track well known indices like the S&P 500 and Russell 1000.

While ETFs that track the S&P 500 and have a reasonable asset base are mostly interchangeable with only minor differences in expenses, direct index strategies are not as commoditized or uniform and therefore require more due diligence when considering options.

Here are three “Ps” of manager due diligence to consider when evaluating direct index providers:

People
As with other investment strategies, it’s good to know there is an established team with direct indexing- specific tenure running the strategy. Managing a process that implements a highly customized strategy is completely different than running an index fund or an ETF. Direct indexing experience is important. A team with a long track record running a large account base is likely to have run into the many unusual situations that can arise when customizing thousands of individual client portfolios.

It is also important to consider the other personnel supporting the strategies. The flexibility of direct indexing makes it a very powerful tool for advisors. Capitalizing on that potential requires specialists that can work with advisors to help meet their client’s specific needs and objectives, so having experienced servicing and support staff is critical.

Process
Most direct indexing strategies have similar processes using optimizers and multi-factor risk models. Other approaches, such as stratified sampling, can offer different features and benefits. Even with similar processes, a large degree of variation exists among different providers around certain parameters, such as the number of positions they hold and how they balance the tax benefit of particular trades versus the sometimes-competing objective of tracking the index closely. Research has shown that being a bit more aggressive in terms of harvesting tax losses, even if it means taking on more tracking error, can lead to better after-tax outcomes for clients.

It is imperative to understand whether a provider’s process prioritizes tax loss harvesting or tight index tracking, as these are competing goals and the answer cannot be “both.” The preferred method should align with your specific goals. Are you trying to track the index first, then add tax alpha if you can, or are you trying to generate tax alpha first, and then track the index as a secondary goal? The two approaches are essentially two sides of a single coin, but nuances matter.

It may also be helpful to understand how a direct index manager handles the securities used to fund an account. Highly skilled providers can incorporate these into the portfolio in a tax aware manner. There may be trade-offs to consider between aligning with the index and realizing a large amount of gains, for example. Clients and advisors can often provide input on this decision, but whether that is specified via a realized gain budget (easy for a client to understand) or predicted tracking error constraint (a completely foreign concept to most clients) can vary from manager to manager.

Performance
Evaluating performance gets quite a bit more complicated with direct indexing due to both the after-tax nature of the returns and the customization involved.

Since much of the benefit of direct indexing is tax related, it is critical to look at after-tax returns of both the strategy and the benchmark. Looking at pre-tax returns can provide some insight into how well a particular manager tracks an index on a pre-tax basis. Probably more important, however, is seeing how well the strategy performs after taxes.

Traditional composites may not always provide the full picture. Composites typically exclude accounts with a large degree of customization and direct index strategies often have many accounts with a lot of customization. Asking a manager about the types of customization that may cause accounts to be excluded and how desired customization may cause accounts to deviate from the index return can help provide insight and understanding.

The rate at which a composite has grown over recent years can also affect results. Direct indexing strategies usually generate much higher levels of tax alpha during the earlier years of an account’s life. As a result, a manager who has added many accounts over the last couple of years may look much better in terms of after-tax results than one with more mature accounts. Asking for the information necessary to compare groups of accounts that opened at similar times may provide a more realistic view of the results an investor can expect.  

Conclusion
Direct indexing is a powerful tool that can be very beneficial for the right client in the right situation. This fact has driven rapid growth in these strategies over the past several years. Advisors serving high-net-worth clients will continue to field interest in these strategies. Knowing how to evaluate direct indexing providers properly can help ensure that clients can take full advantage of the numerous benefits direct indexing can provide for suitable clients.

Kevin Maeda is chief investment officer of direct indexing at Natixis Investment Managers Solutions.