Direct indexing offer customisation like Netflix provides to viewers © AFP via Getty Images

In the last two decades, consumers have learned to love customisation. Spotify playlists have supplanted CDs. Streaming video apps like Netflix are quickly doing the same to cable television. The question is whether this trend will hit the investment industry.

Small-time investors can always, of course, pick out a handful of individual stocks to bet on. But for people looking for broad exposure, pre-packaged products, such as mutual funds or ETFs, have been basically the only game in town.

These funds are fine for most people. However, another option is emerging that gives investors diversification as well as the ability to pick and mix their stock holdings as easily as they select burrito fillings at Chipotle.

So-called ‘direct indexing’ products, which allow this sort of customisation, are still in their nascent stage in the retail market. But a string of recent acquisitions suggests the fund management industry believes they will be a big growth area.

They are different from traditional funds because the end investor owns the individual stocks outright, instead of holding shares or units in the investment vehicle. So, if a retail investor wanted to obtain broad exposure to the US market, they could choose a direct index product that gives them ownership of each of the individual stocks in the S&P 500 or a fraction of each share.

The key thing, though, is customisation. If, for example, that retail investor wanted to have S&P 500 exposure but not hold gun stocks, they could exclude them. Or, if an investor already held a large position in a single company, perhaps because of stock-based pay, they could reduce exposure to its shares in the direct indexing product.

In the past, this is a form of fund management that would have been available only to the wealthy, who could afford to buy broad stock exposure directly.

Then late last year, two Wall Street giants placed bets on mass-market offerings: BlackRock bought Aperio, while Morgan Stanley bought Eaton Vance, and its subsidiary Parametric. Parametric, which manages more than $300bn, is the largest player in the market by a wide margin. Aperio oversees about $36bn.

The deals were an “obvious acknowledgment that this is the wave of the future”, says Dave Nadig, chief investment officer and director of research of ETF Trends, an investment industry website.

On one hand, active asset managers may see direct indexing as a way of fighting back against the low-cost passive funds that have besieged the rest of the industry.

Thanks to new technology, fractional shares and commission-free trading, customisable funds are becoming much easier to roll out to the masses. “With software, it’s trivial to maintain thousands of stock portfolios and rebalance them or put whatever spins you want on them,” says Mr Nadig.

One of the other attractions of direct indexing funds is that they can help investors cut their taxes. Through a process known as “tax-loss harvesting”, direct indexers can systematically sell losing stocks and replace them with similar holdings. This allows investors to offset capital gains taxes incurred on their winning bets, while maintaining basically the same overall exposure.

Direct indexing also solves a tricky problem for sustainability-minded investors. There is no shortage of environmental, social and governance funds on the market, but investors and asset managers may not always agree on what counts as green or responsible. With direct indexing, investors do not have to go out and select a whole new fund, they can just drop and add whatever stocks they want.

“There are 1,000 different flavours of ice cream in the world of ESG investing ,” says John Taft, vice-chairman of US wealth manager Baird. “But the ability to screen portfolios to more fully reflect the values of the individual investor — technology enables that in a way that wasn’t possible before.”

The costs of the new products will be critical to how widely they are adopted. Current offerings are not as cheap as basic, vanilla ETFs that track a major index like the S&P 500. But they are more competitive against ETFs or funds that have a more strategy-based approach.

Mr Nadig says that if investors want features such as ESG filters on stock selection or a particular investment style, such as a focus on undervalued companies, direct indexing tends to be cheaper than any packaged product.

There will be markets and asset classes where custom indexing does not make sense — for example, emerging markets and fixed income. But the challenge to traditional fund managers is clear.

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