Direct indexing name needs a makeover, report finds

Direct indexing has risen to prominence recently, but a new report has highlighted a problem — its name.

Direct indexing is an approach to index investing that involves buying the individual stocks that make up an index, in the same weights as the index. A report Tuesday from Hearts & Wallets, a research and benchmarking firm, looks at investors’ reactions to the direct indexing product concept compared to mutual funds, exchange-traded funds and separately managed accounts.

One of the report's main findings is the term “direct indexing” may need to be reconsidered or revised because of confusion. Laura Varas, CEO and founder of Hearts & Wallets, said that’s because, frankly, it’s not an index.

“As soon as you decide you’re going to over- or underweight Tesla because you do or don’t like Elon Musk, you don’t have an index anymore,” she said. “That sounded like work [for investors] or potentially risky. You need to be able to deviate a little from an index and maybe sell a little bit more of this or that.”

The other reason is that there is already another index, Varas said. "Many of our participants used the term broad market ETFs in discussions and were confused as to what the term ‘direct indexing’ meant when broad market ETFs already exist. There was one very knowledgeable user who said that it’s just not an index. He said, ‘There’s no way I can do this on my own.’”

“I’m not a betting woman but if I was, I’d bet that direct indexing would require intermediaries because a lot of people said it’s not something they can do on their own,” Varas said.

The report identified two main benefits of a “direct indexing managed account” based on an analysis of input from participants in focus groups held nationwide. Of the two main benefits, tax efficiency and customization, tax efficiency was clearly the bigger positive.

When asked why customization was seen as a downside, Varas said it was because it was seen as confusing.

“They were confused about it, they thought it sounded like a lot of work,” she said. “When multiple people in multiple cities said it sounds like a full-time job, that’s not a good thing. That doesn’t speak well to this potential feature. The industry needs to seriously think about renaming the technique that we call ‘direct indexing.’”