The future of investing may lie beneath the fund wrapper that has come to dominate money management.
Twenty-six years ago, State Street Corp. revolutionized the investment business with the launch of its SPDR S&P 500 exchange-traded fund, commonly known by its ticker, SPY.
The product was one of the first of its kind: a basket of the S&P 500's constituent stocks that traded together as a single entity on an exchange. Exchange-traded products have since become a near-unstoppable force, with their assets totaling $4 trillion in the U.S. as of July 23, according to data from ETF.com.
But parts of Wall Street believe another model, known as direct indexing, could dominate the next era of investing.
"The size of the opportunity is the size of the ETF market," said Josh Levin, co-founder and chief strategy officer of OpenInvest Co., which operates an asset management platform that enables direct and custom indexing, in an interview. "There's nothing that this won't ultimately disrupt."
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With direct indexing, investors hold the individual securities that lie beneath an index in a separately managed account rather than in a fund. By working with an asset manager, the investor is then able to customize their portfolio's holdings based on environmental, social and governance factors, preferred tilts or existing exposures they may have in other investments. Another core reason why investors use direct indexing is for tax-loss harvesting purposes, where underperforming investments in the portfolio are sold off and swapped out with other names in an effort to lower the taxes on the portfolio's capital gains.
With roots predating SPY, direct indexing has largely been used by wealthier and larger investors due to the scale required to own the hundreds, if not thousands, of securities included in an index.
"You need a good chunk of change," said Ben Johnson, director of global ETF research at Morningstar, in an interview. Johnson does not see direct indexing as a threat to the ETF market, in part because of the customization that already exists. He also questioned the added cost of direct indexing when the market already has a menu of "very low-cost, near no-cost, exchange-traded funds."
Yet, parts of Wall Street are now working to bring the model to the masses amid rising demand for bespoke investment strategies.
"Direct indexing has an opportunity to take a material and meaningful share of [flows]," said Brian Langstraat, CEO of Eaton Vance Corp.-owned Parametric Portfolio Associates LLC, in an interview. "At the root, the product is all about customization."
Parametric first started using direct indexing in the early 1990s when a family office was in search of a strategy that could achieve the same returns of an index and allow the manager to remain aware of the portfolio's capital gains and losses.
Nearly 30 years later, Parametric has since expanded its direct-indexing clientele with endowments, pension funds and registered investment advisers using the strategy for anything from tax management to ESG investing.
Other companies, such as Wealthfront Inc., have also pushed into direct indexing in recent years. The California-based company offers clients what it calls stock-level tax-loss harvesting for no additional charge beyond its annual 25-basis-point advisory fee that includes all commissions, according to its website. In a white paper published on its website, Wealthfront calls the practice "the next evolution of index investing."
Wall Street still has a few sizable hurdles to clear before direct indexing can become broadly available, though.
To fully democratize direct indexing, asset managers must be able to facilitate fractional shares in their clients' accounts, said Dave Nadig, managing director of ETF.com, in an interview. Doing so would open up a rush of other technological and regulatory questions for those companies to solve, Nadig said, but he still believes direct indexing represents one of the biggest threats to the ETF industry over the next five to 10 years.
OpenInvest does use fractional shares with its direct indexing offerings, which has allowed the company to require only a $100 minimum investment from individual investors. Levin said the company is able to serve direct indexing to both mom-and-pop investors as well as larger investors because of its scalable technology. The company recently also started providing financial advisers access to a new platform called Optimus that allows them to deploy direct and custom indexing strategies for their clients.
"We're just scratching the surface here," Levin said. "It's ultimately coming for the whole industry."