Four considerations for active managers launching direct indexing strategies

It comes as no surprise that direct indexing has grown substantially over the past few years. Thanks to its flexibility to simply track an index, customize to meet ESG preferences or manage taxes by harvesting tax losses at the individual lot level, direct indexing is top of mind for investors, sponsors and asset managers alike. In fact, a recent study by MMI and Cerulli shows that direct indexing solutions are a top product priority, with more than double the number of executives at asset management firms rating them a priority for 2022 as compared to the previous year.

While direct indexing is nothing new, it has become a hot item in the industry over the past few years. Assets doubled between 2019 and 2020 and have continued to grow in the years that followed. Looking ahead, McKinsey expects direct indexing volume to grow to more than $430 billion as asset managers launch new products to meet investor demand.

WHAT IS DRIVING DIRECT INDEXING GROWTH?

Direct indexing strategies have grown in popularity as investors increasingly prioritize having control over their investments. These strategies offer a more flexible and personalized approach to investing in broad indexes and even allow for the implementation of individual ESG preferences. Additionally, with hundreds of individual stocks held in a direct indexing portfolio, there are extensive opportunities for tax loss harvesting. Direct indexing portfolios – along with other SMAs – can take full advantage by harvesting losses in underperforming stocks, which is a popular approach to maximizing losses in down markets.

In today’s bear market, tax loss harvesting has ramped up as investors seek to offset gains with this year’s losses. In fact, at Archer, we have seen nearly double the amount of tax selling requests 2022 as compared to in 2021 . Certainly, as tax optimization remains top of mind for investors direct indexing will continue to take center stage. New technology is also fueling adoption. In the past, direct indexing required labor-intensive management and trading across portfolios. But today’s digital investing platforms and fractional share trading capabilities have made direct indexing more accessible to mainstream audiences. With technology like Archer’s doing the heavy lifting, more asset managers can offer personalized investments at scale and launch their own offerings.

GETTING DIRECT INDEXING OFF THE GROUND

As direct indexing gains traction in the market, we are seeing an increased number of asset management firms looking to launch their own products. Many firms that are primarily focused on equities are eager to enter the direct indexing market but are not sure where to start. Should these products be sold by the same teams that are selling their active strategies? What are the implications for technology? How do they stay competitive and get noticed? For those managers, here are a few considerations:

1.  Understand that it’s a different sale: The team that sells your active strategies might need to shift their approach when selling direct indexing products. Direct indexing is relatively new, and sales teams need to be prepared to properly educate advisors and clients on how it fits into a portfolio. Generally speaking, direct indexing strategies don’t necessarily take the place of other investments, but rather complement traditional portfolios by enabling higher levels of customization.
2. Think about the up-front experience: Consider how to set appropriate guardrails around the level of customization within portfolios. For instance, is the customization taking place at the advisor level or should that be done at the asset manager level? You will also need to set expectations around how performance will be measured, particularly if the objective is tax management, to ensure clients fully understand how their preferences and customizations are impacting their investments.
3. Consider how you will service it: New technology can enable trading of fractional shares, which is critical to creating direct indexed products. But there may be technology limitations among other players in the ecosystem that may need to be considered as you determine what support services and tools you will need to drive adoption and keep clients satisfied.
4. Plan ahead to scale: Any new successful offering will need to have a clear pathway to profitable scale. This is where technology can help drive efficiencies and keep costs manageable. Asset management firms will need to ask themselves what level of service they will provide for smaller accounts as well as how they will deliver advice at scale. Adopting technology that frees up managers to spend time on client-facing, revenue generating activities will be crucial to success.

DON’T GO AT IT ALONE

When launching a new product, it always helps to have access to tools and expertise that can anticipate and solve problems before they arise. Direct indexing is no different. As adoption continues to grow, new technology solutions have emerged that make servicing, managing, and scaling these accounts a much more seamless and profitable endeavor. All firms looking to get started should consider partnering with a tech and solutions provider that can help them through this process. In the end, it could make a critical impact in launching a successful direct indexing offering.