The Post-Fund Paradigm Shift: Direct Indexing Is the Financial Future

Published on

February 25, 2021

What is direct indexing?

Innovations across hundreds of years in the financial sector have paved the way for direct indexing. Starting in the 17th century, individual stocks were the first form of investing. Without the sophisticated regulation and financial vehicle structure we know today that allows for pooled investments and funds, this was the only option. However, given the high cost of brokerage fees, they were inaccessible to the majority of the population.

Then in the 1920s, a more simple and obtainable way for individuals to invest and have a diversified portfolio came along in the form of mutual funds. Although investing in a firm or trust did exist in the 1700s, it wasn’t a common investment option. Not until the 20s, 30s, and 40s did the SEC create any kind of law or regulation around mutual funds for investors.

As mutual funds evolved over time, they were often hailed as a tremendous innovation for offering greater accessibility and diversification than their financial predecessors. The downside for many is that mutual funds often have front-end loads, back-end loads, and much larger tax burdens due to capital gains and trading restrictions.

To reduce that cost and overhead, ETFs made their debut as the innovation of the 1990s. ETFs can be traded like stocks and offer a smaller tax burden in comparison to mutual funds, but they still do not allow for any customization.

This is where direct indexing comes into play. Direct indexing is one of the most modern, dynamic ways you can invest today. Direct indexing allows an investor to purchase all the underlying securities in a given benchmark or index, enabling increased customization and personalization. Additionally, direct indexing supports greater tax efficiency through tax-loss harvesting. With direct indexing, an investor can trade off losses and gains in building out their portfolio directly, advantageously harvesting losses from stocks throughout the year.

In 2016, OpenInvest launched the first Dynamic Custom Indices (“DCIs”) production platform

With direct indexing, what’s old is new again and for the first time in a long time, buying individual stocks is back on the table for more people than ever before. This power of customization in a portfolio allows for individualized decisions centered around an investor’s values, beliefs, and situation.

As we look forward to this post-fund future with direct indexing, we can expect that the greater customization and flexibility will increase the prevalence of ESG investing.

The rise of direct indexing

In the early days of direct indexes, or custom separately managed accounts (SMAs), the service was primarily reserved for institutional investors and high-net-worth individuals with enough money to pay for manual customization of their portfolio. In order to avoid the tax repercussions of mutual funds, some mutual fund managers would create SMAs that mirrored their own funds for larger clients. This made the service expensive and therefore inaccessible to the masses.

In the last few years, advances in cost structures, technology, and increasing consumer demand have made direct indexing, once a manual process at the high-end of the market, a more attractive and accessible solution. These advances are dissolving the entire rationale for investing via funds and across the next few years, we could see direct indexing push funds out the door entirely.

Changing cost structures

One of the first big changes that we credit with this shift was in October 2019 when Charles Schwab eliminated the online trading commission for U.S. stocks, ETFs, and other options. However, companies such as Apex and Folio have been offering free trading since 2014.

What started with Charles Schwab and these early trendsetters resulted in a domino effect of other leading institutions following suit. These commissions were one of the driving factors in the inaccessibility of direct indexing and what made it only a specialty option for the wealthy investor. By reducing the commission to $0, the shift towards accessibility began.

Advances in technology

The advancements in digital investing platforms have also improved this accessibility. Developments, such as OpenInvest’s Dynamic Custom Indexing (DCI), make direct indexing fully automated by managing the scale, speed, and complexity of thousands of concurrent customizations at the individual security level. This automation removes the manual labor involved in replicating an ETF and replacing individual stocks. This enables advisors to create custom-built portfolios for each of their clients.

DCI works by looking at the relationship of the movement in price over time of the shares. This process leads to custom changes in the portfolio. It then responds dynamically by breaking apart and rebalancing the portfolio in real-time, ensuring tight tracking of the index. Then DCI has an integrated front-end to allow advisors and clients to interact with the software and leverage its capabilities.

This customization enables advisors to build client portfolios around their values without having to sacrifice financial goals. This is customization like we’ve never seen before where you, as an advisor, can pull out a tablet live in a client meeting, tailor a personalized portfolio based on your client’s values, and launch custom models on the fly.

Consumer demand for customization and ESG

Consumer demand has also pushed forward the need for further customization. As we’ve mentioned before, a new generation of investors is emerging and this generation is highly interested in values-based investing. The 86% of millennials who are interested in sustainable investing are looking to their advisors for the level of customization they desire centered around their interests, values, and beliefs.

As direct indexing mainstreams as the preferred investment strategy, clients will be more and more inclined to customize their investments based on emotive issues rather than just cost or tax savings.

A millennial investor, for example, might want to have an S&P 500 portfolio but also might want to support women in leadership and divest from fossil fuels. Before direct indexing, this level of customization would not be possible without a pricey and timely manual process from the advisor.

For example, let’s say a client wanted to invest in the S&P 500 but was hoping to exclude companies that are part of the fracking or mining industries. Unless there was an ETF that allowed this level of customization, you’d have to manually go through and purchase individual stocks that met their criteria to build their own version of a fracking and mining-free S&P 500.

With direct indexing, an advisor can build affordable and customizable portfolios that screen out what their clients don’t want, add in what they do want, and strategically navigate any financial risk at the individual security level.

The same idea applies to direct indexing. Perhaps you want to invest in the S&P 500 but wish to exclude Big Tobacco from your holdings. Unless there happens to be an ETF that specifically meets your investment criteria, your only option historically would have been to purchase 498 individual stocks and exclude Philip Morris and Altria Group from your portfolio.

As millennials enter their peak earning years and we gear up for “The Great Wealth Transfer” of earning power from baby boomers to younger generations, direct indexing will offer this flexibility and customization that these generations desire and ESG investing will grow as a result.

The post-fund paradigm shift

This movement of assets from boomers to millennials promises to put $40T into the hands of the biggest, most diverse, most transparent, and most socially-conscious generation in history. As these generations get their hands on increased customization options this will create an explosion of portfolio customization that will require the entire financial industry to move into the post-fund future.

As history demonstrates, the financial sector is known for developments that enter the scene and change the whole game. ETFs were predicted to surpass mutual fund assets, and now direct indexing is the next change to the investment landscape.

This rise of direct indexing is very similar to the rise of music streaming taking over CD sales, only, unsurprisingly, the financial sector lags a bit behind the times. Both fall right in line with this trend towards pick-and-choose customization over rigid, traditional, and inflexible options. What the rise of music streaming can tell us about direct indexing is that as the landscape modernizes, the offerings must follow that demand.

Matt Hougan, CEO of Inside ETFs, along with Dave Nadig, Chief Investment Officer and Director of Research at ETF Trends, understand the need to meet that demand and predicted at the 2019 Inside ETF conference that direct indexing “is the next $100 billion advisor opportunity.”

“If you believe all the statistics that 80 percent of investors want to put an ESG sleeve on their portfolio—and as the Generational Wealth Transfer happens and more wealth is controlled by Gen-X’ers and below, that ESG is going to rise—the best way for it to rise in many aspects is in a direct indexing context where I can customize that portfolio to meet my precise view of what matters in society,” Hougan argues.

In this post-fund future where it's cost-effective to build portfolios around financial gain and personal values, it will become hard as an investor to justify paying an advisor to manage the same funds as the person next door. Your clients want customization. As this customization becomes more cost-effective, this is an opportunity that you won’t want to miss as an advisor.

This is especially true as the financial landscape becomes more competitive and you are struggling to justify your fees in a more modernized and technologically advanced space. A customized and personalized solution for your clients through direct indexing offers a great opportunity for client engagement and retention.

The next advisor opportunity

As advisors, direct indexing is an opportunity for improved customization, more efficient tax-loss harvesting solutions, and an opportunity to attract and engage with your prospective and existing clients. Instead of serving as a salesperson for fund families, as an advisor, you can become a “master of software,” customizing and making smarter and more value-aligned investment decisions for your clients with ease.

What’s even better is that as the data changes, as ESG data often does, the software can be updating your clients’ portfolios in real-time. This ensures that their values are always aligned with their investment decisions. A board elects a new woman. Gender pay gap data expands to European mid-caps. A team of scientists publishes the best new data for water risk in Sumatra. Once validated, that data can flow right through the relevant portfolios, ensuring they remain up-to-date. These infinite combinations can’t be cost-effective with a fund, but it’s made possible with direct indexing.

According to Hougan, advisors stand to be the big winners in the move toward direct indexing and we agree. That’s why at OpenInvest we have fully automated direct indexing end-to-end, with modules designed to empower existing players and systems.

Interested in learning more? Sign up for a demo today or reach out to our team at advisorservices@openinvest.com.


Investment in securities involves the risk of loss. Past performance is no guarantee of future returns. One cannot invest directly in an Index. Any opinions, estimates and forecasts offered in this document constitute judgment as of the date of the materials and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information contained in this document to be reliable but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only and it is not intended to provide and should not be relied on for investment, accounting, legal or tax advice. OpenInvest may not have verified (and disclaims any obligation to verify) the accuracy or completeness of any information herein that has been provided or obtained by third parties.

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