Bringing direct indexing in house? Here's what you need to know.

As of 2021, direct indexing portfolios represented 22% of the overall Separately Managed Account (“SMA”) market at $363 billion in assets.1 Fueled by advances in technology, this number is expected to grow more than 12% year over year according to Cerulli’s US Managed Accounts Report1 as more wealth professionals adopt these strategies to help solve for the evolving needs of a wider client base. We believe the growth potential could be even higher.

Expanding your client base

Direct indexing has been around for decades. It has historically relied on high-touch services and resource-intensive processes, potentially limiting the investors who can benefit from direct indexing to UHNW client segments and limiting the firms that can offer it to specialized SMA managers.

But that’s changing.

New technologies are making direct indexing more approachable, helping wealth firms streamline and automate processes across their business so that advisors can provide truly personalized portfolios without overwhelming their operations.2

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New technologies are making direct indexing more approachable.

Over the past 10 years, client demand for personalization has both increased and become more complex. Beyond expressing security preferences and executing tax loss harvesting opportunities, clients look to incorporate preferences such as value-based investing, more sophisticated tax management, ESG, and so on. 

The interaction of all these flavors of personalization, in our view, creates complex portfolio construction and implementation needs. The demand for tailored, client-focused service delivery places even greater emphasis on technology-led solutions that provide the computing power required and can handle the operational complexity of optimizing portfolios at scale across an entire business line.

Taking it in house

Increasingly, we have observed wealth firms are looking for ways to bring direct indexing in house. As we have seen advisors make greater use of outsourced technology solutions in recent years, they’ve paid a premium to specialized SMA managers to gain access to their staff of subject matter experts and proprietary processes.

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Our view: firms are realizing that they can build or buy solutions in house that allow them to recapture fees.

Firms that build or buy technology solutions in house are recapturing fees they’ve been paying to outside managers, providing more value to clients, and reducing their costs. In our recent experience, different segments of the wealth market have taken different approaches to bringing direct indexing in house.

The largest firms with sufficient technology budgets are attempting to own proprietary technology for direct indexing themselves.3 In our opinion, this may require more than dollars; firms will need to make sure they have the specialized knowledge and tools in their teams for both implementation and ongoing operation. It stands to reason then, that there may be vendor fees to consider with necessary pieces of the tech stack equation, like optimization capabilities and risk model coverage. Because of this, wealth firms who have the capital may be predisposed to acquisitions, buying direct indexing SMA managers or fintech providers outright to gain access to (and control over) their proprietary approaches and optimization platforms. We saw a wave of M&A activity in 2019 and 2020 in this space, and there are relatively few providers left to buy today.3

For most firms, building and acquiring direct indexing platforms are not realistic options, given significant upfront costs, integration timelines, the expertise needed to deal with complexity, and the pace of competition for direct indexing dollars. Instead of continuing to outsource to direct indexing investment managers, these firms can consider ways to “insource” by working with technology providers. 

Going beyond the components

In our view, firms that build their own capabilities using outside providers often contend with stitching together multiple technologies. They also have to figure out how to commit specialized expertise to ensure all the components of the optimization process effectively incorporate their firm’s views. The alternative to this “do-it-yourself” approach can be to find a technology provider that can commit to supporting the implementation process and continue to provide ongoing service beyond the software itself with dedicated resources to scale personalization and streamline the experience.

While many technology providers can help wealth managers bring a powerful, differentiated direct indexing product to fruition, finding the right technology provider whose service goes beyond their software requires due diligence. Technology solutions described as “turnkey” may ultimately require more work and resource allocation down the line, making it harder for wealth firms to maintain them in a quickly evolving marketplace. Looking for how (or even if) they integrate with existing processes, how much work it will take to configure the optimization process, and their ability to evolve over time are all important considerations. 

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Insourcing can still require significant expertise and integration – the right technology provider and service can be a game changer.

For many firms, going beyond component providers and working with the right multi-faceted technology provider may be the path forward – for expediency, quality, ongoing innovation, and to ensure direct indexing capabilities are seamlessly woven into their broader tech stack. Said differently, insourcing isn’t a simple decision with a technology provider. It takes long-term thinking, technology integration, and durable relationships.

5 things to look for in the right technology provider

Here are some technology considerations that can – and should in our experience – make an impact on wealth managers’ decision-making process:

  • You can get direct indexing up and running much faster if the new technology plugs and plays with your existing systems and processes; such as performance reporting, pre-trade compliance, and order management. Consider a service-oriented provider that has a track record of successful integrations and ongoing innovation.

  • Systems that account for tax considerations, ESG preferences, householding across accounts, sleeving and UMA structures – all while ensuring adherence to investment frameworks of the firm – can position wealth managers much better when handling complex personalization. Consider a provider that has built real back-end rigor into these components and can show how they can all work together for your use case.

  • Tailored solutions can really shine when they let you and your advisors express the unique value your firm can bring to client relationships. Look for a provider who has deep direct indexing expertise, can accommodate your firm’s investment views, advice strategy, and specific needs into technology configurations, and who can help you drive adoption with your advisors once everything is up and running.

  • Certain human actions are necessary in direct indexing, and if that isn’t accounted for in your workflows, your costs could be higher than expected from the automation you are implementing. Look for a provider who understands the role an overlay team needs to play on an ongoing basis and has built workflows for them to engage while still running optimization at scale in the background. The proper balance may help reduce costs that would otherwise have been paid to outsource a less efficient workflow.

  • You cannot optimize in a vacuum. Changes made to any holdings – even small tweaks – can impact the risk profile of the entire client portfolio. Some technologies tackle the risks for each part of a portfolio separately, missing critical asset correlations, in our view. Others address risk first and then afterwards add in facets of personalization through tax, preference, or value-based trades, causing immediate deviation. Consider a provider that can deploy a risk optimization engine with the modeling tools and computing power to address the whole portfolio across construction, monitoring, and rebalancing, providing timely insights for your portfolio managers and advisors across different asset classes, like funds and individual equities, at the same time.

Achieving growth through integrated technology

Aladdin Wealth™ is an enterprise solution that can comprehensively assist firms in bringing direct indexing in house quickly. Leveraging built-in risk oversight capabilities and a wealth-native optimization approach, alongside our ongoing service and subject matter expertise, Aladdin Wealth client firms can create durable customer relationships that evolve as markets and clients do and better grow their business.

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This isn’t a simple decision. It takes long-term thinking and collaboration.

Our Personalized Portfolio Management Technology (“PPMT”) is designed as a single overlay portfolio technology that plugs and plays with existing accounting and order management systems. PPMT includes a fit-for-purpose user interface to monitor optimized portfolios that allows you to scale processes across tens of thousands of accounts while balancing central automation and user control in a way that’s right for your firm.

Learn more about PPMT and how Aladdin Wealth™ technology can help you deliver sophisticated direct indexing to more clients.

1Source: Cerulli US Managed Accounts Report, 2021
2Source: Cerulli US Managed Accounts Report, 2020
3Source: Aggregated list of publicly known M&A from industry publications and press releases: Fidelity bought Ethic 9/2019, Goldman bought Motif book 4/2020, Schwab bought Motif Tech 5/2020, Morgan Stanley bought Parametric 10/2020, BlackRock bought Aperio 11/2020, JPM bought OpenInvest 6/2021, Vanguard bought Just Invest 7/2021, Franklin bought O’Shaughnessy 9/2021, Morningstar bought Moorgate 9/2021, Prudential bought Green Harvest 10/2021.