Thread by @MichaelKitces

The direct indexing trend continues, and the heels of Vanguard acquiring JustInvest and JPMorgan acquiring OpenInvest in just the past few months... (1/?)

"Franklin to Buy Custom Indexing Firm O’Shaughnessy to Help Personalize Portfolios" on.wsj.com/3oA4e4z

Notably, though, there's a shift already underway in how Direct Indexing platforms are getting positioned, compared to the deals last year when Morgan Stanley acquired Parametric and Blackrock acquired Aperio. (2/?)

In the case of Parametric and Aperio, the deals were positioned more as a distribution play - mega firms acquired 'traditional' direct indexing providers to distribute their (largely HNW) direct indexing strategies to a wider client base. (3/?)

But Parametric and Aperio were largely 'first generation' direct indexers, built around replicating traditional indices and capturing the tax-loss harvesting benefits of the more granular stock ownership. Particularly appealing for HNW clients in top tax brackets. (4/?)

By contrast, the 'second generation' of direct indexers didn't come from asset management; instead, they were born of #FinTech, built as technology platforms that provide investors the levers TO replicate their indices of choice. (5/?)

However, second-gen direct indexers that provided the tools to replicate indices were really just portfolio construction tools to built any kind of stock-based portfolio using a formula. That formula could be 'replicate S&P 500'. But it could also be 'screen out tobacco'. (6/?)

In fact, many of 2nd-gen direct indexers had specific ESG-filtering tilt (e.g., JustInvest, OpenInvest, Ethic Investing, etc.). Though it isn't exclusive to ESG. Advisors could similarly express DFA-style factor tilts through direct indexing tech. (7/?) kitces.com/blog/what-robo…

In essence, the 2nd-gen direct indexers have begun to tilt direct indexing away from a pure "replicate the index in stock components" into "adapt the stock components of the index into whatever the client wants or needs". Which is really about customization/personalization. (8/?)

O'Shaughnessy's Canvas direct indexing platform had leaned particularly heavy into this, distributing their solution into advisors, leveraging high-profile firms like @ritholtz as early adopters (e.g., ritholtz.com/2021/04/access… ) and quickly amassing over $1B in 1 year. (9/?)

As there are LOTS of applications for personalization in the advisor context. Not just advisor investment strategies (ESG, factor tilts, etc.), & tax benefits (TLH for HNW clients), but also building around existing client positions, individual company exposure, etc. (10/?)

And it seems asset managers are noticing, as more and more are moving to acquire direct indexers. Eat and absorb your future competition before it eats you? Thus the deals from Vanguard and now Franklin Templeton in particular. (11/?)

Notably, though IMPLEMENTATION of direct indexing at scale is still challenging. It introduces unique trading difficulties for advisors who may start trading large quantities of individual stocks at the click of a button, after years of being mutual fund & ETF focused. (12/?)

Which makes direct indexing in the advisor context especially conducive to an outsourcer who takes on the responsibility to do the actual trading, while the advisor constructs client portfolios using the tech. That was the OSAM Canvas model (13/?)

Relative to traditional industry, that's straightforward to leverage - it's basically an SMA, but one where the advisor sets strategy at the client level, and then the SMA manager trades/implements using their size and scale. Natural fit for Franklin's $130B SMA business. (14/?)

Still, though, while direct (and now increasingly customized/personalized) indexing may look like a 'traditional' SMA alternative, it is more profound. Because the level of client customization potential provides a unique differentiator for advisors to each client. (15/?)

And advisors are increasingly desperate to differentiate. Not to mention that when every client's portfolio is personalized to them, it's basically impossible to benchmark performance. Which gets advisors out of the constant benchmarking challenges. (16/?)

This is why Sequoia staked Vise to a stunning $1B valuation despite just ~$250M of AUM. Because if direct indexing tech becomes the new building block for advisors, it threatens the entire mutual fund & ETF complex that is powered by advisors today. (17/?) kitces.com/blog/indexing-…

Ultimately, because CUSTOMIZED indexing in particular is expressed through tech, the quality of the tech tools TO construct those portfolios will become a key differentiator. OSAM's Canvas was strong here (shout out to @patrick_oshag). Good deal for Templeton. (18/?)

But again, the key is that in the long run, growth of direct (& increasingly personalized) indexing isn't just a function of SMA growth. It's the potential to change the building block of portfolios away from mutual funds and ETFs. Which is a multi-trillion-$ opportunity! (/end)