In Defense of Direct Indexing

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When several financial institutions recently announced their plans to enter the direct indexing (DI) space, a barrage of articles attacking the practice hit the blogosphere. Those arguments rhyme: Direct indexing is “active” and undiversified; it makes sense only for taxable accounts; its tax management capabilities are limited; or that it is complex and expensive.

None of these claims are true. My firm, Mercer Advisors, began using directing indexing solutions in 2016. Today, we have nearly $3 billion in UMA-compatible direct-index portfolios across most major asset classes. Client demand is strong, fees are low (on par with index funds and ETFs), and returns have been fully in-line with established benchmarks.

Direct indexing and active management

Many have argued that direct indexing is just another name for “active management.” While I’m a huge proponent of passive and factor investing, the argument that direct indexing is akin to active management is imprecise.

What defines “passive”? Vanguard-style cap-weighting? If there’s no room for multifactor indexes, how then do we have indexes such as the Russell 1000 Value and MSCI USA Diversified Multifactor Index? How then do we categorize strategies managed by firms such as Dimensional Fund Advisors or AQR Capital Management? To argue that direct indexing’s diversified, formulaic, and rules-based approach to portfolio construction is somehow analogous to traditional active management – an approach that is almost always discretionary and non-rules based – couldn’t be more inaccurate.