The ESG case for direct indexing

Companies see it as an area for growth given tax benefits and customization

There are different views on what constitutes responsible investing and how sectors or companies should be weighted or excluded – and that is making direct indexing increasingly appealing for some advisers.

So much so that observers project direct indexing use to grow at a faster rate than those of mutual funds and ETFs, even as it is easier and cheaper to build an ESG-friendly portfolio with those off-the-shelf products.

The service seeks to replicate indexes while excluding securities investors don’t want – usually those with fossil fuels or other environmental baggage. It’s a type of separately managed account that, while far from being a new idea, has recently been proliferating as an option from companies like Vanguard, Fidelity, Charles Schwab and Morningstar.

Direct indexing “is a result of the evolution of ESG and socially responsible investing,” said Andy Kunzweiler, portfolio manager in Morningstar Investment Management’s direct indexing business. With mutual funds, “the investor – the end user – really gives up control over the definition of ‘ESG’ or what constitutes a suitable investment to the index provider.”

Morningstar, which today formally launched its program, found in a recent survey that the majority of advisers use direct indexing for some clients, and nearly all are planning to if they do not currently, Kunzweiler said.

“Qualitatively speaking, direct indexing is something that comes up in almost every conversation that we’re having, because it just makes so much sense, and it’s a powerful tool for advisers to offer their clients,” he said.

Make it custom

There is hardly a shortage of sustainable mutual funds and ETFs on the market, with new ones being added almost every day. But the prospect of providing clients with a custom portfolio, catered to their moral guidelines, is something that advisers see as an extra value to their services.

Added to that is perhaps the main selling point of direct indexing – tax benefits. By owning shares of stocks outside of funds, investors can use tax-loss harvesting, or offsetting taxable gains of some securities with losses on others.

“It’s critically important because the definition of ESG is so scattered – there isn’t one standard for the industry, let alone individual consumers. It means different things to different people,” said adviser Robert Persichitte, whose firm Delagify Financial uses an exclusion model for companies he believes are unethical.

“Popular ESG evaluation software uses more than 24 unique categories that may or may not be necessary to an individual. For example, manufacturing medications for abortions may be considered a positive for some and unethical for others,” Persichitte said.

“The flexibility for the individual investor to decide empowers them to make the best decisions possible for their own conscience.”

For example, one of his clients wants to support the circular economy, and that portfolio excludes companies involved in consumer non-durables. Most often though, people ask to have fossil fuels removed, he said.

Adviser Katherine Fox, founder of Sunnybranch Wealth, has been using direct indexing with clients for five years. The three main draws of the approach are tailoring portfolios to values, proxy voting on socially responsible guidelines and tax efficiency, Fox said.

“Some clients may care exclusively about climate and water issues but not at all about racial or gender equality. That client would put different screens on their portfolio than a client who was primarily focused on social justice and promoting diversity, equity and inclusion but cared less about environmental causes,” she said.

“I recommend that clients move into direct indexing for the impact and ESG capabilities, but the tax piece is an important side benefit that can indirectly reduce the cost of the investor’s portfolio.”

Interest piqued

A survey in June of 2,000 individual investors commissioned by Charles Schwab found that 46% of those with ETFs are interested in learning more about direct indexing, with a third saying they’re very likely to choose the service during the next five years.

Nearly 40% of ETF investors said they plan within the next year to invest in line with their personal values, Schwab found.

Use of direct indexing is projected to grow at a rate of 12.4% annually through 2026, according to a report last year from Cerulli – faster than the growth pegged for ETFs (11.3%), mutual funds (3.3%) and other types of separately managed accounts (9.6%). As of early 2021, estimated assets in direct indexing services in the US were about $363bn, according to Cerulli, and a separate Morningstar analysis has put the current total close to $500bn.

The top providers, as of last year, were Morgan Stanley, BlackRock, Fidelity, Columbia Threadneedle and Natixis Investment Managers.

Among managed account sponsors Cerulli surveyed, ESG was not the leading opportunity they said they saw for direct indexing. Nearly all cited ongoing tax optimization as the top opportunity, while about 80% said tax management for accounts transitioning to direct indexing was a major or moderate opportunity. Behind that was ESG, with 16% of providers saying it is a major opportunity and 39% calling it a moderate one.

High net worth

Despite the increasing number of direct indexing options, it’s not something familiar to most people, in part because separately managed accounts have been reserved for the very wealthy.

With more services coming to the market, account minimums have gone lower, making it more accessible, but interest among investors is slow to catch up.

“Inbound demand is low, due to a lack of knowledge rather than a lack of interest. I use direct indexing in all my client portfolios,” Fox said.

“As technology pushes down cost and barriers to entry, direct indexing makes sense for high-net-worth clients, when previously it was typically reserved for ultra-high-net-worth investors.”

Adviser Jeremy Eppley is planning to add a direct indexing service for clients of his firm, Silverstone Financial, he said.

“My custodian, Altruist, rolled out S&P 500 direct indexing capability with a $2,000 account minimum this year and has promised to roll out single-stock and SRI/ESG screens to direct indexing portfolios in 2023,” he said.

“I will be using this to as my US large-cap exposure for lower costs, better tax efficiency and (when available) the ability to avoid specific companies or entire industries. I personally will end up using this for my own personal portfolio and plan to screen out at least the tobacco companies from my S&P 500 holdings.”

Higher cost

Direct indexing best fits clients who have at least $500,000 to invest, and it’s ideal if that money isn’t already allocated to mutual funds and ETFs, said Kirsten Crane Cadden, an associate adviser at Warren Street Wealth Advisors, said.

“Direct indexing is a useful strategy to reduce the concentration of company stock or other large single security positions with embedded gains that may already exist in a client’s portfolio,” Crane Cadden said. “Accounts with existing ETFs and mutual funds can be tax loss harvested and redeployed into a direct index strategy.”

But compared with most funds, direct indexing is costlier. Clients with portfolios built with sustainable funds and ETFs might be used to slightly higher fees than those in vanilla index funds, given that ESG often involves active management – but the costs of direct indexing may still be higher.

“The fees for direct indexing management are generally a bit higher than managing a traditional brokerage account,” Crane Cadden said. “Direct indexing accounts also require more hands-on maintenance and involvement (which will be handled by your adviser).”

However, the higher costs can be offset by the benefit of tax-loss harvesting, Morningstar’s Kunzweiler noted. Tax efficiency and ESG “kind of go hand in hand,” he said.

“You get the ability to fully customize a portfolio,” he said. “Combine that with the tax benefits of the approach, and it’s very powerful.”