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"Direct indexing" is the next step in the development of index ETFs

"Direct indexing" - direct indexing - allows investors to customize indexes to create "custom" investment portfolios, taking into account personal preferences in terms of investment factors:

● bias towards cost or quality,

● personal environmental, social and governance beliefs (ESG),

● to minimize tax liabilities.

Possibility to choose and mix.

Over the past 20 years, consumers have loved personalization. Spotify playlists have supplanted CDs. The Netflix streaming app does the same with cable TV. Will this trend affect the investment industry?

For individual investors seeking broad market exposure, the only option is off-the-shelf mutual funds or ETFs.

Such funds are suitable for most people.

However, another option has emerged that gives investors the opportunity to diversify - choosing and mixing stocks is as easy as choosing toppings for pies and pizza.

The cost of new products will be critical to their widespread adoption. Current offerings are more expensive than ETFs that track major indices. But they are competitive with ETFs or funds that take a more strategic approach.

Differences from traditional funds.

The investor owns the individual shares directly.

Instead of ETF shares or investment company units. With a direct indexation product, an individual investor can gain broad exposure to the US stock market. And take ownership of each of the individual stocks in the S&P 500, or a portion of each stock.

Individual approach.

If an individual investor wants to have access to the S&P 500 and not own gun stocks, they can exclude them. If an investor already has a large equity position in one company, he can reduce that company's stake in a direct indexation.

In the past, this form of management was available only to rich people who bought a wide range of shares directly. Thanks to new technologies, fractional stocks and commission-free trading, custom funds are becoming much easier to implement for a large number of small investors.

"With the software, thousands of stock portfolios can be easily maintained, rebalanced or given any look," says Dave Nadig, chief investment officer and research director at ETF Trends.

Tax cuts.

Direct indexing funds will help investors cut taxes by systematically selling unprofitable stocks and buying similar ones. This will allow investors to offset capital gains taxes, while maintaining a nearly equal overall distribution of investments. And the tax efficiency of ETFs could disappear.

Orientation towards sustainable development.

There is no shortage of environmental, social and governance (ESG) funds in the market, but investors and asset managers do not always agree on what is considered "green" or responsible. With direct indexing, investors don't have to search the market for a brand new fund - just drop and add any stock.

"There are 1,000 different flavors of ice cream in the world of ESG investing. Technology allows portfolios to be customized to better reflect the values ​​of the individual investor. This has not been possible before," says John Taft, vice chairman of U.S. asset management firm Baird.

"...if investors want features like ESG filters when selecting stocks, targeting undervalued companies, or custom investment style, then direct indexing is cheaper than a bundled mutual fund or ETF product," said Dave Nadig.

activity of financial companies.

"Direct indexation" products for individualization of investments at the stage of inception in the retail market. But a number of recent acquisitions in the fund management industry suggest that some of Wall Street's big names see the prospect of rapid growth in a "pick and mix" approach.

In November 2020, BlackRock shelled out $1.05 billion - about 50 times its underlying earnings - for Aperio, a direct indexing pioneer with $36 billion in assets.

In October 2020, Morgan Stanley bought Eaton Vance for $7 billion to acquire a Parametric subsidiary with more than $300 billion in individual client portfolios.

In September 2021, Franklin Templeton announced the acquisition of O'Shaughnessy Asset Management (quantitative asset management company). With this acquisition, Franklin Templeton will add to its offerings in the rapidly growing separately managed account industry.

Solactive (a German index provider that provides the benchmarks underlying about 500 $100 billion ETFs) and Ned Davis Research (a $1.5 billion independent Florida-based research firm) have signed an agreement to provide indexes and C8 models Technologies for the London-based global platform. Institutional and professional platform investors will be able to customize portfolios according to their own requirements. S&P Dow Jones Indices, Green Blue Invest and Thomas Schumann Capital are also involved in the project.

Timo Pfeiffer, Director of Markets, Solactive:

"...I have no doubt that such a development will happen. This is the evolution of ETFs, a new type of asset management and the democratization of investments. If an ETF issuer or sponsor turns a blind eye to any element of direct indexing, then it will be overtaken left, right and center. The concept is already ready to reach individual investors in the US."

"...So far, Solactive has licensed over 100 indexes to C8 Technologies, and more indexes are in the pipeline.

Pension funds can use the platform to track the index and exclude companies involved in controversial activities. Alternatively, an investor might want to pick the 100 highest dividend companies in the index, or equalize the stock weights to include the size factor. There is no limit to creativity."

"... direct indexing will be an option in the broad retail market in the US in the next 2 years and in Europe within 5 years. It will start with large institutions, pension funds, wealthy people. Then you can do it from your mobile phone. "

Mattias Eriksson, founder and CEO of C8 Technologies:

"...the company has about 25 investor clients and $100M in assets, up from $20M a year ago. We aim to reach $1B by December 2021.

We have 7,000 strategies to choose from. We work with pension funds, sovereign wealth funds, funds of funds, family offices and corporate treasurers. Chinese organizations showed particular interest. This will be a big step forward. We're starting to see what the future holds."

Brian Sanborn, Vice President of Investment Solutions at Ned Davis Research:

"...the growth of environmental and religious investing requires individual decisions. Some investors may want to change the Ned Davis indices due to geographic restrictions or combine strategies.

Everything can be made to order if there is data. The only limits are data availability and your imagination. That's the beauty of technology."

"...Direct indexation and ETFs are 'complementary' instruments with different strengths and weaknesses. Self Indexing saves institutional investors the expense of fund manager due diligence. For smaller investors, direct indexation can be more expensive than ETFs."

So far, Europe and the rest of the world are lagging behind the US, where direct indexing was developed. The C8 Technologies platform is only available to institutional investors. In the US, the concept of "direct indexing" is common among wealthy private investors.

However, it is hoped that as technology continues to improve and costs come down, access will spread down to individual investors.

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