Morningstar - Q3 2022 - 14

Dispatches
Direct Indexing for All?
Although the service
is now widely available,
it is not for most.
IVORY TOWERS
John Rekenthaler
Ten years ago, " liquid alts " were the rage.
Investment organizations 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) individualized portfolios. Today's
trend is direct indexing. Seemingly every major
company is on board.
In 2020, Morgan Stanley MS bought a directindexing
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 Indexing. Great
minds think alike. Then again, so do sheep.
(Morningstar MORN also announced a directindexing
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 owners of index funds
possess one investment, those who index directly
typically hold dozens or even hundreds
of securities, depending on 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
14
Morningstar Q3 2022
will the portfolios of both the fund investor and
the direct indexer.
Holding the stocks directly, as opposed to through
a fund, permits personalization. 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 customization 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 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 0.3% 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 0.4%.
Second Wave
Effectively, direct indexing is the updated version
of separately managed accounts. 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. They 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. Using a financial
advisor is, of course, pricier because of the
second layer of fees, but total annual expenses
are still 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.
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 directindexing
services can implement such choices
is an advantage.
The Promises
Marketing material for Schwab Personalized
Indexing summarizes the pitch for direct indexing.
To quote, the Schwab program is:
gCustomizable
Select an index for the market exposure you prefer,
including an environmental, social, and
governance option. You can also exclude a limited
number of stocks to reflect your preferences.
gTax-Efficient
Tax optimization seeks to minimize tax liabilities
and have your portfolio potentially outperform the
index on an aftertax basis.
gProfessionally Managed
Portfolio managers at Schwab Asset Management
https://www.morningstar.com/authors/208/john-rekenthaler https://www.morningstar.com/stocks/xnas/hood/quote https://www.morningstar.com/stocks/xnas/hood/quote https://www.morningstar.com/stocks/xnys/ms/quote https://www.morningstar.com/stocks/xnys/blk/quote https://www.morningstar.com/stocks/xnys/schw/quote https://www.morningstar.com/stocks/xnas/morn/quote
Morningstar - Q3 2022

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