Recently, the direct indexing space has been active, as several large, well-known asset managers have been buying up independently owned shops that invest directly in market indices rather than in ETFs, funds or individually picked securities. McKinsey reports that assets under management in direct indexing have tripled over the last three years to $215 billion, and could double by 2025.1
Why all this interest? Why do managers and advisors appear to see potential in serving clients through direct indexing in taxable separate accounts? We see four key reasons.
- Technology.
Providers increasingly have the ability to customize accounts based on client preferences such as investment strategy, ESG and tax optimization (differing gains, no net gains, etc.). This creates an opportunity for clients to look beyond generic commingled vehicles like ETFs and mutual funds, since advisors can personalize accounts based on individual dynamics such as liability stream, risk profile and charitable gifting in ways that were not contemplated a few years ago.
Second, the costs in running SMA platforms have sharply declined, given the potential ability to draw robo-advisor-like fund flows and employ straight-through processing from the advisor’s opening of a client account online to reporting after-tax performance, and leveraging cloud-based architecture. - Trading costs.
Two decades ago, trading costs for equities were significant, but have since fallen to close to zero in many cases. - Custody costs.
Over time, the price of custody has fallen and continues to fall given that custodians are also leveraging technology to make their operations more efficient. - Tax-efficiency.
In taxable accounts, taxes are typically by far the largest expense—not trading costs, custody, or management fees. One of the biggest advantages of an SMA is loss pass-through—which is not available with respect to investments in mutual funds or ETFs. Indeed, mutual funds are arguably tax-inefficient. Morningstar provides investors with pre- and after-tax* mutual fund returns. Looking across the U.S. Equity Large Blend category, taxes paid (pre-tax return minus after-tax return) are around 3.2% over the last 10 years, on average; the amount is similar for U.S. Equity Small Blend. As a result, if an investor sees their statement generating a 10% annualized pre-tax return, that return may be 7% after-tax, based on current federal tax rates. The difference between pre- and after-tax returns is less of an issue with tax-efficient SMAs, as tax-efficient SMAs seek to reduce negative returns on pre-tax capital, given their ability to harvest losses. At Neuberger Berman, we provide several active strategies with tax overlays, along with other customizations.
The Bottom Line
We are of the view that we are in the early innings of investors owning securities directly in market indices using custom wrappers. In our view, investors can more closely align their investment, liability and risk objectives by direct indexing through customized separate accounts rather than owning commingled funds like mutual funds or ETFs in taxable accounts.
