Stay Informed

News and information you can use.

Direct Indexation and The Demand for Personalized Portfolios


There are four main obstacles to building wealth for consumers: procrastination, poor spending habits, inflation, and taxes. Of the four, two are personal, one is systemic, and the last is, regrettably, unavoidable.

Most wealth managers work hard to increase their clients’ after-tax returns by reducing the taxes from their investments. This was usually done by avoiding transactions that generated short-term capital gains and using tax efficient investments such as ETFs or equities that do not pay dividends in taxable accounts.

One product that is taking off recently is direct indexing, referred to as “the Great Unwrapping” by Matt Hougan, CEO of Inside ETFs. This name is apt because direct indexing can provide a personal index to every investor using a custom approach to maximize tax-efficiency without requiring the overhead of the ETF structure — the wrapper.

Institutional investors achieve the same tax-savings by using separately managed accounts (SMAs) for their HNW clients. Because of their wealth, the clients of these institutions have had a great advantage over smaller investors; until now. The power to directly invest into custom portfolios that can mirror any index now exists for everyone.

A Tax Evolution Over Mutual Funds and ETFs

Designed to help investors reduce their investment tax-burden, direct indexing may offer tax benefits not available in pooled vehicles such as ETFs and mutual funds. These benefits primarily derive from the ability to conduct ongoing tax loss harvesting inside the index.

A 2019 study by Aperio Group found that after-tax returns of SMAs that mirrored index portfolios could go as high as 1.93% per year as compared to just 0.81% for ETFs. And Aperio’s findings align with other similar studies. Parametric, a leader in custom portfolios, conducted a similar study comparing ETFs and SMAs and asserts that the “return advantage can be as large as 2% annualized on an after-tax, after-fee basis.”

Direct indexing requires the selection of securities based on the target indexes, client preferences and investment goals. This could be achieved with an SMA, which could hold every security in the index. However, the cost to buy even one share of each security in the S&P 500 would require an initial investment that has historically made such an option not available to many investors.

A Strategy for Everyone

Direct indexing has become more accessible to the mass affluent thanks to three factors: automated portfolio optimization technology, the collapse of trade commissions to zero and expanded support of fractional shares by technology vendors and custodians.

For wealth managers looking to offer direct indexing to affluent investors, trading fractional shares has many attractive features such as low account minimums, tracking error minimization, and exceptional ease of managing portfolios. Thanks to these factors and features, the promise of greater tax-savings and easy delivery has created a clear path for Main Street to Wall Street.

It’s a road that larger players have already taken. There has been a series of consolidations where companies are attempting to quickly gain or improve their direct indexing capabilities. This past September, Goldman Sachs announced that it acquired custodian Folio Institutional, as part of a larger strategy to expand their client base by incorporating direct indexing into their RIA services.

Before the Folio Institutional acquisition, Goldman Sachs acquired the technology and patents of Motif Investing, one of the pioneers of digital and thematic investing.

In October, signaling to the industry that direct index is the next thing, Morgan Stanely and Eaton Vance entered into an acquisition agreement. Once the acquisition is completed, Morgan Stanly will own Eaton Vance’s subsidiaries Parametric and Calvert, a leader in responsible ESG investing.

Others see the trend and are contributing to the movement. FTSE Russell has begun licensing its indexes to SMArtX Advisory a wealth technology vendor and TAMP. which is making available direct private company investments. As well as expanding it’s roster by 60 investment strategies and include industry leaders like Fidelity Institutional Asset Management, Northern Trust Investments, and Vanguard Group.

The rollout of Charles Schwab’s commission-free trades has amplified the disruptive quality of direct indexing technology. “The size of the opportunity is the size of the ETF market,” said Josh Levin, co-founder and chief strategy officer of OpenInvest Co., a direct and custom indexing asset management platform, “There’s nothing that this won’t ultimately disrupt.”

Brian Langstraat, CEO of Parametric, agrees that direct indexing growth will impact the ETF market. Thinking about the future, he says “we’re certainly bullish on [direct indexing]. I think it’s a huge product area, and I think it’s going to be a trillion-dollar product one day, maybe multi-trillion as the industry assets grow. But there are specific use cases for direct indexing. It all comes back to customization.”

Personalization at Its Most Granular

Direct indexing opens up personalized customization at its most granular level. Discerning investors can develop their portfolios from many more index options and selectively include or prohibit investments that do not align with their strategy or goals.

For example, investors can easily exclude sin stocks, like alcohol, tobacco or firearms and replace them with ESG stocks they’d rather support. This will prove to be an important differentiator that drives assets from pooled investments into direct indexing.

With the pandemic still looming large, many ESG analysts, like Celent and J.P. Morgan, have adjusted their forecasts. Now Celent reports, that by 2022, ESG assets are expected to reach $53 trillion, adjusted up from $45 trillion. “Never before have environmental, social, and governance considerations been so relevant,” stated Celent’s Head of Wealth Management William Trout. “Climate stress, racial and social unrest, and millennial-driven scrutiny of business practices across the globe indicate an ESG tipping point.”

Trout further explains his take on this global tipping point. ESG has been elevated above its previous position as a sustainability asset class. Now, it has become the “lens” for all new investment decisions. A development that is quickly taking hold.

This year, Blackrock CEO Larry Fink announced, Blackrock’s commitment to fully integrating ESG into their advisory strategies by the end of 2020. Their commitment states that Blackrock “considers ESG risk with the same rigor that it analyzes traditional measures such as credit and liquidity risk.” A fantastic commitment to their clients, but for those investors going at it alone, this strategy cannot be achieved without direct indexing and the software to manage it.

Predictably, disruptive technology breeds new opportunities. The growing interest in direct indexing has cast a spotlight on well-established technology from the likes of SoftPak; whose MARS software allows any asset management firm to cater to the direct indexing needs of Main Street at scale. Using a mean variance optimizer, MARS is capable of the same analytical rigor that institutional asset managers once only had access to. Savvy mass affluent investors understand the benefits of this technology and want it in their corner.


As world events continue to unfold, concerns about environmental and social issues will percolate into the public consciousness and become greater discerning factors in how investment choices are made. The demand for personalized portfolios will clearly continue to grow in 2021 and beyond.

About SoftPak Financial Systems

One the earliest players in FinTech, SoftPak has developed innovative products at the intersection of business solutions and IT infrastructure since 1994. Our rule-based rebalancing and risk-based optimization software powers some of the largest financial institutions in the world, processing over $500 billion in assets. Headquartered in Massachusetts, SoftPak has offices worldwide.

Click on the link below to have a Softpak representative contact you with more information.

Contact Us