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Direct Indexing Is Like Customizing a Tesla, But With Your Portfolio, Investor Says

Brendan McDermid | Reuters

You can customize clothing, jewelry and automobiles, so why not a portfolio?

That's the idea behind direct indexing, which allows investors to purchase the stocks of an index rather than a mutual fund or exchange-traded fund.

Once reserved for the ultra-wealthy, the strategy is now hitting the mainstream, with Vanguard, BlackRock, Morgan Stanley and others building out offerings to help people personalize their positions based on risk profile, environmental, social and governance considerations, and other factors.

"Think of it like self-driving money," Patrick O'Shaughnessy, whose firm runs a platform called Canvas that enables customized investing, told CNBC's "ETF Edge" on Monday.

"You set the conditions ... for your own personal index and from that point forward, the firm manages the trading, whether that's tax-loss harvesting, complying with some custom request that you have, etc.," he said. "To the advisor and eventually to the end investor, it'll feel like just the next generation of any technology, just like using Stitch Fix for customized clothing or ... building a Tesla online."

Investors are using direct indexing in a range of ways including to capture tax benefits, reduce positions in stocks or industries tied to their professional work, or make ESG-related adjustments, O'Shaughnessy said.

Though only 20% of Canvas accounts are ESG-conscious, they run the gamut when it comes to exclusions, with many cutting exposure to carbon-emitting names and at least one ruling against positions in companies that produce sugary drinks, he said.

"The demand is there for people to have their own strategy built just for them based on their circumstances and their preferences," the O'Shaughnessy Asset Management CEO, principal and portfolio manager said.

"When we give people these tools in a custom index platform or a direct index platform, about 80% of them completely customize their strategy. So, I think this is where the world is going. Technology allows this to happen. Better to own the stocks directly and unlock the benefits of doing so versus own them indirectly through an ETF."

Though customizable separately managed accounts have been available to high net worth investors since the 1950s, this newfound accessibility could make for a major shift in the way the mass market invests, Dave Nadig, chief investment officer and director of research at ETF Trends, said in the same interview.

Importantly, the fees can't get much higher, Nadig said. Though direct indexing can't yet compete with ETFs charging 3 basis points for their strategies, providers can "absolutely" charge 20 to 40 basis points for the strategy, which is still a relatively competitive fee, he said.

"I think it's a bit inevitable that we're going to get to this more customized way of approaching investments," Nadig said. "Being able to manage precisely to your needs really does matter in the long term."

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