Vanguard could propel values-based direct indexing from niche to essential

The Vanguard Group Inc.’s jump into values-based, direct indexing via its acquisition of Just Invest could further cement the investment strategy as the next wave for wealth managers to secure profits. 

Vanguard announced Tuesday it will acquire Just Invest, an Oakland, California-based manager of $1 billion known for its direct-indexing capabilities. Investors and advisers can use tools like Just Invest to construct portfolios that reflect their personal values, while benefiting from tax optimization. With the acquisition, Vanguard is ready to profit on hyper-personalization trends and differentiate itself from rivals, said Capco's managing principal Robert Norris.

Today, direct indexing has become a powerful strategy for the mass affluent, propelled by growing investor interest around environmental, social, and corporate governance and advancements in technology, Norris said. Direct indexing, which refers to buying a sample of individual stocks that will track the performance of an index, was once historically seen as a niche or specialized offering. 

“Wealth managers are now asking themselves the critical question: How can I align my clients’ values with their investments in their portfolios?” Norris said. Moving forward, Norris said he expects companies to increase investing in behavioral science tools and data, which will feed the engine of direct indexes that they are acquiring. 

When Vanguard, the world’s second-largest asset manager with a history of cost disruption, jumps into trendy investment strategies, the industry should prepare for it to become the future, said Tim Welsh, President, CEO and founder of Nexus Strategy. 

“Warning bells should be going off at high decibels at all of the fund companies letting them know that their traditional bread and butter operating expenses and profits they get from producing mutual funds and ETFs may be at risk and they will have to respond quickly,” Welsh said. “Look for any technology firm or boutique asset manager that has anything with ‘direct indexing’ on their website to be acquired.”

According to Cerulli, 67% of asset managers believe direct indexing represents the most immediate opportunity to manage both tax and ESG factors. According to Morningstar, money flowing into U.S. funds categorized as sustainable hit a record $51.1 billion in 2020, more than double the 2019 record of $21.4 billion, a third of which came in during the fourth quarter of that year. 

“This is a signal that direct indexing has become table stakes,” said Steve Zuschin, executive vice president of enterprise technology adoption at LifeYield. “Vanguard has led the industry in driving costs down for investors. I’m sure they’ll do the same for what was once a specialized offering.” 

ESG, too, is clearly a game changer both in terms of asset flows and requirements for portfolio personalization, said Javelin Strategy’s head of wealth management William Trout. 

“We’re not in the land of the plain vanilla mutual fund anymore, Toto,” Trout said. “These demands for personalization, notably among the Millennial investors who are the future of our industry, are driving the adoption of interactive platforms such as Just Invest that deliver an interactive, tactile experience that guides the investor through the customization process click by click.” 

To be fair, Vanguard is standing on the shoulders of many firms that have already prioritized direct indexing, as evidenced by acquisitions over the last year. Michael Kitces wrote in his July adviser tech column that it is increasingly becoming clear that direct indexing is the “next big thing” of the 2020s thanks to the cycle of acquisitions. “As both investors and incumbents make their direct indexing bets and put the pressure on other major firms to establish their direct indexing strategy,” Kitces said. 

Charles Schwab acquired the technology of Motif in May 2020 to accelerate development of thematic and direct indexing technology. Morgan Stanley acquired Eaton Vance for $7 billion in October 2020 that gave access to Parametric, which manages $300 billion of direct indexing portfolios. 

BlackRock announced its acquisition of Aperio for $1 billion in November 2020, which bolstered it’s separately managed account assets under management by 30% to $160 billion and represents a shift from BlackRock’s ETF business which totals $7.8 trillion in assets, according to Capco. 

Moving forward, expect to see different incumbents adopt different direct-indexing strategies based on their clientele, Kitces said. For example, Morgan Stanley pursued Parametric for a tax-centric direct indexing offerings for their tax-sensitive high-net worth clients, but JPM pursued OpenInvest for a more ESG-centric custom indexing offering for their mass affluent banking clientele, Kitces said.