Assets in direct indexing products are growing at a double-digit annual rate and are poised to reach $800 billion by the end of 2026.
Several factors are bulwarking that growth, including the increased accessibility of UMAs, client demand for customization and the inherent tax benefits of having more positions and opportunities for tax-loss harvesting.
Tech platform Envestnet, one of the largest UMA providers, is in the middle of the direct indexing trend. Its subbrand QRG offers over 100 portfolios across four core series (market, factor, sustainable and fixed income). (Users can also invest in direct indexing portfolios managed by third-party managers as well.)
WealthManagement.com sat down with Brandon Thomas, co-founder and co-chief investment officer at Envestnet, to discuss trends in direct indexing.
This interview has been edited for style, length and clarity.
WealthManagement.com: Starting with a 30,000-ft. view, can you describe the current state of direct indexing and its usage by advisors?
Brandon Thomas: It’s really taken off in the last three to four years. It’s accelerated as advisors have gotten more acclimated to it. It’s an approach that has been around for decades in the institutional world, but more recently, because managers can more easily optimize portfolios and because advisors are demanding strategies that are lower cost and tax efficient, direct indexing has accelerated. It’s the fastest-growing product on the Envestnet platform, and I'm excited about its future.
WM: What are the primary benefits of direct indexing?
BT: First, the cost. These are SMA (separately managed account) model portfolios of individual securities, so they are comparable to other SMAs. Most active SMA strategies are 40 basis points-plus. Direct indexing costs are down in the mid-teen range. A lot of advisors are moving to them simply because of this.
A second benefit is that direct indexing is very transparent in terms of objective, strategy and outcome. Advisors are tired of explaining the underperformance of active strategies while paying for them. They know clients are better off having investments that track the asset class that they have set up in their asset allocations. When managers underperform benchmarks, it hurts long-term outcomes.
Tax management is also another key benefit. Most direct indexing will hold many more positions than a traditional active strategy or passive ETF. That creates more opportunities for tax-loss harvesting and offsetting gains with losses. ETFs are inherently tax efficient, but you can customize when getting into a direct-indexed SMA.
And that would be the fourth benefit. Generally, you can create a bespoke direct indexing strategy from scratch easily that aligns with values, could have factor tilts or could have a yield overlay. There are a lot of different options from a customization and personalization standpoint in direct indexing that aren’t available in ETFs, index mutual funds or active SMAs.
WM: How does direct indexing sit alongside or integrate with things like model portfolios, SMAs, UMAs and ETFs?
BT: Envestnet is one of the largest UMA (unified managed account) providers. Advisors are adopting the UMA construct over SMAs very rapidly. Having direct indexing in an UMA is critical and what we are seeing advisors adopting as a core/satellite approach. We tend to call it active/passive. We will use, for example, a U.S. large-cap strategy to go passive but then will use active ETFs, active mutual funds and other strategies on satellites such as U.S. small-cap, emerging markets and some of the niche fixed-income asset classes. It’s nice a combination of active/passive where, if you can identify a manager that will consistently outperform in a niche asset and pair it with a low-cost index. We are seeing a lot of advisors adopt that approach.
WM: What are the minimums to be able to access direct indexing strategies?
BT: The standard on the Envestnet platform is $100,000 for a large-cap strategy. You will have about 175 positions in a strategy like that and a diversified portfolio. We do have a version that’s $60,000 that has fewer individual security positions and instead has allocations to some underlying asset class ETFs. That’s not as popular. The $100,000 minimum is nice for advisors using UMAs. They can apply direct indexing to more of their clients now. If they have a client with $250,000 of assets in a UMA, the $100,000 sleeve fits nicely. And we can fit an all-cap allocation or a large cap allocation in that sleeve. Most direct indexing managers that only do SMAs are still at a $250,000 minimum.
WM: Why do you call your products “quantitative portfolios”?
BT: Essentially, that’s a brand name. Envestnet is a tech platform. QRG Capital Management is a subgroup, and quantitative portfolios describe what we do. Everything we do is from a quantitative perspective. We don’t do fundamental evaluation of securities. We ingest enormous amounts of data and analyze it algorithmically. The portfolios are quantitatively constructed and systematically managed, hence the brand name.
WM: Explain your four broad buckets--market, factor, sustainable and fixed income
BT: We have a broad definition of direct indexing. Traditionally, it’s pure beta large cap. We certainly have that, and it’s our most popular and it's part of our market series. It’s a pure passive strategy and not trying to outperform. It tracks the index as closely as possible in an optimization framework.
The factor-enhanced products are still quantitatively managed, but there we are applying research and factors, such as value, momentum, quality, low-volatility, etc. It tilts toward those types of companies in and strives to outperform the index over time. Factors in academic research have shown the ability to generate excess returns. So, it’s not orienting portfolios in market-cap weight, but overweighting companies that have exposure to those asset pricing factors to outperform the index.
The sustainable portfolios are more of ESG type of strategy or faith-based. It’s not trying to outperform. It’s trying to track the index as closely as possible but also orient toward companies that have high sustainability metrics or low carbon footprints or match other types of values, those types of things.
And then we have our bond ladders, which are very passive. Bond ladders are our fastest-growing suite of products.
WM: And those are where you have bonds with varying maturities, and as they mature, you rotate in new ones?
BT: That’s right. A $100,000 portfolio might own 20 bonds and if it’s a 10-year ladder, you would have two bonds mature each—say one in March and one in September—and as they mature, the proceeds are reinvested. They keep rolling down. It’s a buy-and-hold approach. There’s no trading activity. The proceeds accrue and are reinvested.
For the market series, we have 100 different strategies. In the factor series there are multi-factor combinations and single-factor strategies. The sustainable suite has ESG, thematic and faith-based. And then in fixed-income we ladders for corporate, munis and Treasuries and there are five-year and 10-year versions.
WM: Among your market, factor, sustainable and fixed income portfolios, do you see any trends in terms of allocations based on the underlying shifting macroeconomic conditions?
BT: We do track that. Most of the assets have always come into the market series because it is the easiest to understand. Within market series, it’s mainly large cap and U.S. all-cap and some international and a smattering of other asset classes.
In the fixed-income world, it’s interesting. We rolled that suite about 2 1/2 years ago, coinciding with the rise of the Fed Funds rate. Advisors were looking for higher yields. That’s why it’s been the fastest-growing percentage-wise. When you see rates tick up, more assets flow into bond ladders. And because factor performance hasn’t been that strong in the last couple of years, we haven’t seen as much on a relative basis. There are also a lot of headline issues with ESG and the like. ESG has been a popular strategy in the institutional world but hasn’t caught on in the advisor-managed space. That’s been consistent for eight years now. That suite has lagged over that entire time.
WM: Any expectations for 2025?
BT: It will be interesting seeing what interest rates do. The 10-year right now is at 4.6%. There’s a lot of analysis that shows that the 4.5% level is a threshold above which advisors and investors start to think more about fixed income than equities. A risk-free rate of 4.5% to 5.0% becomes very attractive to more risky equity strategies, particularly when equities are fairly expensive right now. That’s not to say there’s a huge decline, but on a relative basis, there will be tracking of interest rates to see if some of the policies of the Trump administration are going to be inflationary and if rates stay right on that cusp of investors thinking about fixed income more aggressively.
We have no new product strategies in the works based on what is happening. We are all set in tems of lineups. But we do expect there to be some movement in flows based on interest rates.
WM: How much should we expect to see the overall direct indexing market grow in the near term and long term?
BT: Cerulli and others are projecting some big numbers. The latest report I’ve seen projects direct indexing will outpace both ETF and indexed mutual fund flows. It’s been the fastest-growing product vehicle on the Envestnet platform. And it’s not just the strategies we run, but those from other managers as well. I don’t see it slowing down.
In terms of overall industry assets, it’s a very small portion. It’s grown very rapidly and I don’t see anything slowing it down other than that one of the drivers of growth has been the underperformance of active managers.
One of the reasons for that has been the artificially low interest rate environment since 2009. Active managers have found it very hard to outperform. If rates normalize and if we do see some active managers outperform on a more consistent basis, that could eat into the growth rate of direct indexing a bit. But even with that, I think it’s here to stay because of the fee structure, the customization and the tax management benefits that can be applied. I don’t think anything that will slow it down.
WM: Lastly, are there any common questions, concerns or misconceptions you hear from advisors about direct indexing?
BT: There aren’t a lot of concerns about it. I’ve been doing this for 12 years. One that comes up is that there can be some shock when clients see the number of positions that on their brokerage statement. If you think about a UMA, which is a single custodial account that could have multiple managers, ETFs and mutual funds in it, it can be one account, and you could be used to seeing just a handful of funds. If an advisor moves to direct indexing and uses a couple of account managers, suddenly, you have 300 positions. That can overwhelm investors. It’s more of an optical issue. From an investment standpoint we are used to talking about it and the reasons for it, even having positions that amount to a couple of shares. But that kind of thing is the only pushback that we’ve heard.
