Direct Indexing Grows, but Plans Don’t Vary Much, Morningstar Says

Direct indexing, which has found favor with institutions and financial advisers that seek to tailor traditional indexes to beneficiaries’ preferences, is expanding rapidly. But a Morningstar study found that the different offerings from Wall Street firms are pretty much the same.

To meet investors’ requirements, these providers customize bespoke indexes that do such things as omit tobacco stocks or include those with high environmental, social and governance scores.

Of the $260 billion invested in direct indexing strategies at year-end 2022 (other estimates are higher), “providers have similar offerings,” the research group found in its survey of Wall Street firms and others. Family offices have used these strategies and some employers are said to be eyeing them for defined contribution portfolios.

Direct indexing has been around for years, but current-day computing power has accelerated its use, according to the report by Jason Kephart, Morningstar’s director of multi-asset ratings, and his team. Also, a batch of large asset managers—such as BlackRock, Morgan Stanley and Franklin Templeton—have recently acquired smaller competitors, broadening their range.

The category is poised for growth. Cerulli Associates projects that direct investing will expand at a 12.3% annual rate through 2026, outpacing exchange-traded funds (9.5%) and mutual funds (minus 2%). The latter two categories are, and will continue to be, many times larger than direct indexing, the consultancy estimates: $7.1 trillion and $20.8 trillion, respectively. Cerulli puts direct investing’s current asset size, at $462 billion, higher than does Morningstar, which employs a different gauge.

For Morningstar, examining the beefed-up competitors in the direct indexing field resembles “comparing different chain restaurant menus.” The study said, “Sure, there are small differences, but the core offerings look alike.”

Starting fees range from 0.23% to 0.40%; they usually fall as account sizes increase. Accounts of around $5,000 usually have just three indexes they can choose to customize, mainly the S&P 500, MSCI All-Country World and MSCI Europe, Australasia and Far East indexes. Larger accounts get to add more, such as the Russell 2000 and MSCI Emerging Markets.

From there, Morningstar added, investors can “choose their own adventure,” although it will come from a standard palette.

The one area that is tough to parse among the direct index providers is how these firms go about their “tax harvesting,” in which they offset gains with losses, . Extending the fast-food metaphor, Morningstar referred to these methods to a “secret sauce.”

At the same time, other large players who have belatedly entered the scene are struggling to catch up and boost their offerings, Morningstar found. For example, JPMorgan offers just a U.S. large-cap direct indexing option, and Charles Schwab has four indexes covering U.S. large caps, international large caps, ESG and small caps. Both only started in direct indexing last year.