Direct Indexing has become increasingly popular in the US over the past decade. According to Oliver Wyman, between 2015 and 2020, assets grew at a 30% compound annual rate to $350 billion USD.

Direct indexing has started to penetrate the Australian market but has not taken off in the same way. Are we on the cusp of similar growth?

What is direct indexing?

The easiest way to think about direct indexing is directly owning all of the underlying assets in an index while retaining the capability to remove any security you don’t want to hold.

For example, an investor could choose the ASX/200 and remove any exposure to banking shares.

Ultimately, it is a Separately Managed Account (SMA) with the ability for individual investors to customise the underlying holdings.

Why would investors use direct indexing?

The classic case for direct indexing is for investors concerned about ESG. Local direct Indexing provider Nucleus Wealth allows investors to customise your portfolio from a range of screen and tilt options. These include ‘animal rights’, ‘religion’, ‘climate change’ and ‘war’.

For example, if I chose climate change, they allow me to choose whether I want to exclude:

  • Fossil fuels (worst offenders)
  • Fossil fuels (any)
  • Coal Seam Gas or Fracking
  • Nuclear Power
  • Old Growth Forest Logging

They also offer tilts – including investment style factors such as quality stocks or growth stocks, thematic tilts and GICS sectors to name a few.

Exclusionary tilts can also serve investors who want to invest in Aussie equities, but don’t want the narrow exposure to resources and financials offered by passive investments. This is a valuable feature. Australian investors with small balances cannot purchase individual equities. This could also be an attractive proposition for investors that own large individual positions in certain shares and don’t want to double their exposure through a heavily concentrated index.

One of the largest reasons why investors choose to use direct indexing is because they are able to avoid the tax implications of other investors’ decisions. This has always been a drawback of collective investment vehicles – you’re pooling your funds with other investors to benefit from scale, but that means you also share the inflexible tax costs. These vehicles require capital gains to be distributed to the investors, but direct indexing allows you to control when you realise capital gains which may reduce tax liabilities for long-term investors.

How much does it cost?

There are usually multiple fee components to a direct indexing product:

  • Investment fee for the actual investment product
  • Trading fee for any trades that are made to buy and sell holdings
  • Administration fee for the platform that the product is hosted on

The Australian direct indexing industry is still nascent. Nucleus Wealth is the major player in the market, with competitors starting to build out their offerings. Nucleus’ products are available on several platforms. Here is an illustrative example of what an investor would pay for their direct indexing product on Interactive brokers.

The fees below are inclusive of administration and investment fees, with trades costing 0.099%. The management fee starts at .385% for balances under $250,000 and reduces to .11% for more than $10,000,000. 

The base indexes that investors can access are managed by the investment manager and are an amalgam of S&P and MSCI methodologies, primarily based on market capitalisation.

Is it worth it?

The judgement that investors need to make is whether the customisation and possible tax benefits are worth the fee, or the hassle.

Portfolio customisation can add a level of complexity to our portfolio that professional management is supposed to remove. After managing your portfolio to account for any ESG, factor or exposure considerations, your portfolio must be monitored and maintained to ensure that the thesis for removal or addition is still valid.

With over 240 ETFs in Australia, there are many different variations of exposure that investors have access to.

For example, if investors wanted access to the Australian large and mid-cap markets, the iShares Core S&P/ASX 200 ETF (ASX: IOZ) tracks the index for 0.05%.

For investors that are worried about exposure, the ETF product market has accounted for this with equal-weighted products such as The VanEck Australian Equal Weight ETF (ASX: MVW). Although the fee is higher at 0.35%, the portfolio is managed to ensure that the holdings always meet the fund mandate and criteria for inclusion.

The classic example of when this didn’t work for investors was with collective investment vehicles in 2008. Regardless of whether you were a long-term investor with a stomach of steel, many investors in these products suffered due to poor behaviour from other investors. The market drop caused widespread investor panic, driving many managed fund investors to make withdrawals. This sudden influx of redemption requests negatively impacted the remaining investors in a few ways:

The lack of liquidity to fund these withdrawals caused assets to be sold at depressed prices, severely impacting performance

The sale of assets caused tax consequences for the remaining investors in the funds

Whether it was correlation or causation, the popularity of Separately Managed Accounts (SMAs) skyrocketed shortly after, where the underlying assets are owned and not influenced by the behaviour of other investors.

For investors with a larger balance, the options that may suit their circumstances are broader. The transaction costs on individual security purchase can be justified, but the potential tax advantages of direct indexing may be significant on larger balances.

For investors that have smaller balances and are investing paycheque to paycheque, direct indexing may suit investors that cannot find professionally managed alternatives that suit the exposure that they require (or prefer) in their portfolio. Direct indexing can also offer options to manage exposure through fractional share investing with no minimum for additional investments depending on the hosting platform (such as Interactive Brokers). This means that small amounts can be distributed across each security with no extra transaction costs.