Direct indexing: not the right solution for everyone
Direct indexing is a growing trend in asset management as customers place more emphasis on personalization and tax efficiency when choosing investment products. It's important for investors to recognize that, like any strategy, direct indexing has its own set of risks and limitations.
Direct indexing has garnered increasing interest due to its ability to provide clients with access to benchmark-like return potential, while also allowing for a higher degree of customization and control, as well as more sophisticated tax management strategies. Cerulli Associates forecasts that the growth of direct indexing will outpace that of mutual funds and ETFs over the next four years.1
Who could benefit from direct indexing?
While this may be a beneficial solution for some investors, it may not be the right choice for everyone. At its core, the objective of direct indexing is to replicate exposure to a specified benchmark while offering investors direct ownership of the underlying securities. Investors who may benefit from direct indexing typically have large investment portfolios and require some degree of customization, perhaps to accommodate a large single stock position or to avoid investing in certain sectors of the market.
Direct indexing is viewed as a hybrid form of investing that combines elements of both passive and active management. Since direct indexing involves some level of customization and intentional deviation from the index, it is in essence a form of active management. This means that direct indexing essentially makes its investors active managers. Investors must ask themselves if they’re comfortable with taking on such a task.
These investors also need to be willing to accept benchmark-like potential returns as a starting point, with any customization of the portfolio possibly leading to a higher level of tracking error. One thing that we think is especially important for investors to keep in mind is that tracking error may lead to significant deviations from the benchmark return and has the potential to increase portfolio risk.
This stands in contrast to an actively managed strategy that also might have elevated levels of tracking error; however, active strategies willingly take on benchmark risk in exchange for the potential to outperform the index. While direct indexing strategies might outperform the benchmark on an after-tax basis due to their ability to generate tax alpha, any potential outperformance on a before-tax basis might not be intentional or repeatable.
Why investors might want to consider an active SMA
In our view, many investors who are interested in direct indexing might be better served by considering an actively managed separately managed account (SMA). One benefit of this type of strategy is that active SMAs can provide investors with access to institutional-caliber asset management teams. In addition, SMAs can offer clients similar customization and tax management benefits as direct indexing while also maintaining the potential for outperformance of the benchmark.
In our view, this is an important benefit as we believe that active management can potentially add significant value within some areas of the market. Active managers also have greater flexibility when addressing the constantly changing risk/return landscape. We believe this helps provide a competitive advantage during periods of uncertainty, such as the late-cycle environment we’re in now.
Can investors customize their SMA portfolio?
Recent technological advances have made customization within SMAs easier than ever, allowing clients to create customized SMA portfolios without sacrificing potentially alpha-producing active management. In other words, active SMAs offer clients the same customization and tax efficiency benefits as direct indexing while also presenting the potential to outperform the benchmark.
Investors should view direct indexing as one tool in the toolbox, along with SMAs, mutual funds, and ETFs. Each comes with its own set of advantages and limitations and investors should carefully evaluate both the opportunities and risks when it comes to selecting which might be the best choice for a given allocation within their portfolios.
SMAs are intended for HNW, investment-savvy individuals and may not be appropriate for all investors.
1 “U.S. Managed Accounts 2023,” Cerulli Associates, 2023.
Important Disclosures
This material is for informational purposes only and is not intended to be, nor shall it be interpreted or construed as, a recommendation or providing advice, impartial or otherwise. John Hancock Investment Management and our representatives and affiliates may receive compensation derived from the sale of and/or from any investment made in our products and services.
The views presented are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Past performance does not guarantee future results.
Diversification does not guarantee a profit or eliminate the risk of a loss.
Alpha measures the difference between an actively managed fund's return and that of its benchmark index. An alpha of 3, for example, indicates the fund’s performance was 3% better than that of its benchmark (or expected return) over a specified period of time.
SMAs are intended for HNW, investment-savvy individuals and may not be appropriate for all investors.
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