Direct indexing looks set to disrupt the retail ETF market
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So-called “direct indexing” is spreading its wings beyond the very wealthy in the US and threatening to disrupt the rapidly growing global retail market for exchange traded funds.
The nascent concept allows investors to customise existing indices to create bespoke portfolios tailored to meet their personal preferences for investment factors, such as tilts to value or quality, their personal environmental, social and governance (ESG) beliefs, and potentially to minimise tax liabilities.
A flurry of corporate activity in the US suggests some big Wall Street names see the prospect for rapid growth of this “pick and mix” approach.
“There is no doubt in my mind that this development will happen,” said Timo Pfeiffer, chief markets officer of Solactive, a German index provider that provides benchmarks, which underpin about 500 ETFs with $100bn of assets.
“It’s an evolution of the [ETF] wrapper. It’s a new type of asset management, frankly, it’s democratising investment,” he said adding that the concept was already on its way to reaching retail investors in the US.
“If I’m an ETF issuer or sponsor and I turn a blind eye to any element of direct indexing, then I will be overtaken left, right and centre. I have no doubt [it will reach the mass market]. That is the big use case.”
Brian Sanborn, vice-president, investment solutions at Ned Davis Research, a Florida-based independent research provider with $1.5bn of assets tracking its models and indices, is another convert.
“We have seen what ETFs have done to mutual funds and direct indexing is going to play a role here. It will change the fund and ETF industry,” he said.
The concept is most advanced in the US, where in November BlackRock splashed out $1.05bn — an estimated 50 times underlying earnings — for Aperio, a pioneer in direct indexing with $36bn of assets. This came just weeks after Morgan Stanley bought Eaton Vance for $7bn, in part to get hold of its Parametric affiliate, with more than $300bn of customised client-specified portfolios.
Solactive and Ned Davis have both signed up to provide their indices and models to C8 Technologies, a London-based global platform that allows institutional and professional investors to customise them to their own specifications. S&P Dow Jones Indices, Green Blue Invest and Thomas Schumann Capital are also on board, according to C8.
Mattias Eriksson, founder and chief executive of C8, said it had about 25 investor clients and $100m of assets, up from $20m a year ago. He is aiming for $1bn by December.
“We have 7,000 strategies to choose from. We work with pension funds, sovereign wealth funds, fund of funds [as well as family offices and corporate treasurers]. It’s going to be big going forward. We are starting to see what is going to be the future,” said Eriksson, who added that interest had been particularly strong among Chinese institutions.
Pfeiffer said Solactive had so far licensed more than 100 indices to C8, with more in the pipeline.
He envisaged that pension funds could use the platform to track an index but strip out companies involved in controversial activities. Alternatively, an investor might want to select the 100 highest dividend payers in an index or equal weight the stocks to incorporate a size factor. “There is no limit to creativity,” Pfeiffer added.
Sanborn said the growth of both environmental and religious-based investing means “there is often a need for customisable solutions”, while some investors might want to tweak Ned Davis’ indices to meet their in-house geographical constraints or to combine strategies.
“Anything can be customised as long as the data is there. The only limits are data availability and your imagination,” said Sanborn. “It’s the beauty of where we have come with the development of technology.”
So far, Europe and the rest of the world have lagged behind the US, where direct indexing was developed. The C8 platform is only available to institutional investors, whereas as in the US the concept has also been extended to wealthy private investors.
However, there is an expectation that as technology continues to improve and costs fall, access will percolate down the food chain.
Pfeiffer forecast that direct indexing would be an option in the broad retail market in the US in the next two years, and in Europe within five years.
“It starts off with large institutions, pension funds, high net worth. This makes it accessible [to those with] $5m, then $1m, but ultimately it will go down. You will be able to do this on your mobile,” he said.
“Direct indexing is gaining momentum in the discussions we have and trends we see in the last few months. It’s taken more time in Europe but it’s hitting the ground as we speak.”
Pfeiffer viewed the threat to ETFs as analogous to technological development in music, where vinyl was replaced by compact discs, which in turn have been supplanted by the likes of Spotify. “It’s the same content but a different wrapper,” he said.
Sanborn, though, saw direct indexing and ETFs as potentially more “complementary” with different strengths and weaknesses. Self indexing saves institutional investors the cost and hassle of doing due diligence into a fund manager but could potentially prove more expensive for small investors, he feared.
Eriksson agreed that, for institutional investors, C8 was “maybe half the price of investing in a fund”.
Despite his optimism about future prospects for growth in direct indexing, however, Pfeiffer has reservations about the likely impact of its widespread adoption.
“I have not said that this will lead to better [investment] results. I don’t think [it will] because to me a standard index, market-cap weighted, is investing in the average of the market,” said Pfeiffer, something research shows that few investors beat over a sustained period of time.
“This is one area of my life where I’m happy to settle for the average. I do not believe that these conscious decisions will improve investment performance.”