By: Randy Bullard, Global Director of Wealth Management.

Direct or personalized index portfolios have been utilized by high net worth investors for over 20 years.  Firms like Parametric Portfolio Associates and Aperio have promoted them through separate account programs, and private client groups and financial advisors have implemented them directly for their high net worth clients.  This slow but steady growth became an avalanche in 2020 as a number of high profile acquisitions, fintech startups, and major wealth direct indexing platform launches were announced, increasing adoption by financial advisors and bolstering interest across the industry.

Direct, or personalized indexing is an investing approach that creates a portfolio of individual securities designed to mimic the returns of an index, such as the S&P 500.  An index-based mutual fund or ETF typically holds all of the constituent members at the appropriate index weightings to deliver returns that closely track the index return.  A direct index portfolio typically includes a subset of the index holdings and will have somewhat higher tracking error or deviation in return to the target index. Whereas an index mutual fund typically delivers single-digit tracking error to its benchmark, a direct index portfolio can exceed 3% tracking error, depending on implementation considerations.  It’s important to note that the deviation is unbiased – the portfolio is as likely to outperform as underperform.

What are the Benefits of Direct Indexing?

Compared to an index mutual fund or ETF, direct index portfolios offer retail investors a number of benefits.  By owning the underlying securities directly, the investor has the opportunity to harvest tax losses within the portfolio while continuing to maintain relatively tight tracking error.  For example, the S&P 500 includes five airline stocks.  A typical direct index portfolio might only include one or two of these stocks given their relatively high risk/return correlation.  If an investor developed an embedded loss in one of these positions, the algorithm could harvest the loss and swap to one of the three or four other airline stocks to maintain roughly the same target tracking error to the S&P 500.  Additionally, an investor’s unique risk or customization requirements can be factored into portfolio construction, resulting in a better fit with the investor’s risk/return tolerance and values.

Why Now?

The explosive growth and adoption of direct indexing is driven by a number of industry developments that have eliminated barriers to adoption, reduced cost, and created the necessary environment for financial advisors and wealth management providers to launch these portfolios.

1) Index Investment Adoption

ETF adoption by financial advisors started in the late 1990s, but accelerated after the 2008 financial crisis. Historically, advisors have favored active asset management and made product and security selection central to their value proposition. In the 2000s, advisors began to transition to financial planning services, focusing on asset allocation rather than product selection.  Advisors have increasingly incorporated passive investment products such as index mutual funds and ETFs into their client portfolios—offering individually constructed index portfolios is the next logical step.

2) The Move to $0 Commission Trading

Historically, trading costs and custodial fees presented the largest barriers to direct indexing.  Direct index portfolios typically comprise 100 or more holdings, depending on the index (or mix of indices) and the size of the client’s portfolio.  Combined with trades for tax loss harvesting, the total volume of trades could result in significant expense to the investor. The move to $0 commission trading by numerous broker dealers[1] has significantly reduced or eliminated the trading and custody costs associated with direct index portfolios.

3) Fractional Share Trading & Custody

Traditional brokerage accounts require customers to trade/own whole shares.  Within a direct index portfolio, this creates tracking error resulting from rounding of positions to whole share positions . A growing number of brokerage and custody platforms now support fractional share holdings and trading, allowing for more accurate implementation and tighter tracking error to the target benchmark.  When paired with $0 commission trading, fractional share trading allows direct indexing to be implemented cost effectively for much smaller portfolios.

4) New Technologies

Direct index portfolio management requires the use of mathematical optimization and risk modeling software that analyzes and generates trade recommendations based on the unique inputs for each client portfolio.  The process also requires the ongoing collection and maintenance of client-specific information, including individual tax rates and realized gains and losses to correctly inform portfolio construction and rebalancing decisions.

Numerous fintech/wealthtech providers have developed new technologies to automate the data collection and financial advice components of direct indexing, along with the portfolio management and trading processes required to support efficient operations across large volumes of individually customized portfolios.

What Does the Future Hold?

These technology innovations and market developments will support massive adoption for direct indexing in the years ahead.  Implementation and operating costs have dropped significantly and account minimums have also decreased, to $10,000 on some platforms[2] and no account minimums on others.[3]

2021 is positioned to be a big year for direct indexing as the 2020 M&A transactions result in new direct indexing programs and product launches.  Venture and private equity funding and investments from major software vendors and wealth management firms will accelerate what’s already one of the hottest segments in the wealth management industry.  Direct indexing provides significant investor value across multiple dimensions, and as advisors become more knowledgeable with this approach, I expect we will see rapid adoption and continued growth in market share across the industry.


Want More? Watch this MMI Advisory Insights interview about The Evolution of Direct Indexing featuring Craig Pfeiffer, CEO of MMI, and Randy Bullard, Global Head of Wealth for Charles River.

Contact Us

To learn more about our Wealth Management Solution or to schedule a demo.


Disclaimers and Important Risk Information

Charles River Development – A State Street Company is a wholly owned business of State Street Corporation (incorporated in Massachusetts).

This document and information herein (together, the “Content”) is subject to change without notice based on market and other conditions and may not reflect the views of State Street Corporation and its subsidiaries and affiliates (“State Street”).  The Content is provided only for general informational, illustrative, and/or marketing purposes, or in connection with exploratory conversations; it does not take into account any client or prospects particular investment or other financial objectives or strategies, nor any client’s legal, regulatory, tax or accounting status, nor does it purport to be comprehensive or intended to replace the exercise of a client or prospects own careful independent review regarding any corresponding investment or other financial decision. The Content does not constitute investment research or legal, regulatory, investment, tax or accounting advice and is not an offer or solicitation to buy or sell securities or any other product, nor is it intended to constitute any binding contractual arrangement or commitment by State Street of any kind. The Content provided was prepared and obtained from sources believed to be reliable at the time of preparation, however it is provided “as-is” and State Street makes no guarantee, representation, or warranty of any kind including, without limitation, as to its accuracy, suitability, timeliness, merchantability, fitness for a particular purpose, non-infringement of third-party rights, or otherwise. State Street disclaims all liability, whether arising in contract, tort or otherwise, for any claims, losses, liabilities, damages (including direct, indirect, special or consequential), expenses or costs arising from or connected with the Content. The Content is not intended for retail clients or for distribution to, and may not be relied upon by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to applicable law or regulation. The Content provided may contain certain statements that could be deemed forward-looking statements; any such statements or forecasted information are not guarantees or reliable indicators for future performance and actual results or developments may differ materially from those depicted or projected. Past performance is no guarantee of future results. No permission is granted to reprint, sell, copy, distribute, or modify the Content in any form or by any means without the prior written consent of State Street.

The offer or sale of any of these products and services in your jurisdiction is subject to the receipt by State Street of such internal and external approvals as it deems necessary in its sole discretion. Please contact your sales representative for further information.

State Street may from time to time, as principal or agent, for its own account or for those of its clients, have positions in and/or actively trade in financial instruments or other products identical to or economically related to those discussed in this communication. State Street may have a commercial relationship with issuers of financial instruments or other products discussed in this communication