With ETFs becoming the darling of investors of all ages, direct indexing looks for opening

New Schwab research shows the growing appeal of exchange-traded funds, while raising questions about whether investors are open to direct indexing.

As wealth management success stories go, it would be difficult to imagine a better mouse trap than ETFs.

When talking about the savvy and innovative financial services industry, it’s never safe to assume something new isn’t around the next corner, but across the past several decades of product evolution, the ETF has struck a chord and appears to have staying power.

This is all being confirmed and reinforced by the latest research from Schwab Asset Management that paints a picture of ETFs as all-weather products gaining appeal across the demographic spectrum of investors.

The report, ETFs and Beyond, builds on more than a decade of research into ETF trends and shows their growing popularity. Among investors already using ETFs, 80% of survey respondents describe ETFs as their vehicle of choice, which is up from 70% two years ago.

ETFs now make up 33% of ETF investors’ portfolios, up from 27% five years ago. Over the next five years, ETF investors expect 40% of their portfolios to be in ETFs. And 93% of ETF investors expect to purchase ETFs in the next two years, while 41% of non-ETF investors also plan to purchase ETFs.

“I personally think ETFs are the vehicle of the future,” said Eric Balchunas, senior ETF analyst at Bloomberg Intelligence.

Balchunas is encouraged by data showing younger investors embracing ETFs.

“That’s a good sign for the future,” he said.

Separating the ETF investor base by generation, the Schwab research shows that 41% of millennials are currently invested in ETFs, which compares to 33% of Generation X investors and 19% of baby boomers.

The top reasons investors are drawn to ETFs include low fees, ease of use and the ability to customize portfolios.

“When you look at the data and think about why investors tend to use ETFs, cost is top of the list,” said David Botset, head of equity product management and innovation at Schwab Asset Management.

“But it’s also about exposure to the underlying index,” Botset said. “The research is starting to tell you a bit about how much cost matters.”

The research for Schwab’s 11^th annual ETF report included a survey of 2,000 investors between the ages of 25 and 75 with at least $25,000 in investible assets. Half of the survey respondents had traded an ETF in the past two years, while the other half had not.

One of the things that encouraged Botset about how investors are using ETFs is the way investors have generally navigated the past few years, which have included extreme market volatility, inflation, interest rate hikes and geopolitical unrest.

“We used the volatility we were experiencing in the markets to gain insights into investors,” he said. “What we saw in the outcome of the survey was that in many cases investors appear to be using ETFs for more strategic allocations. In each case, investors said the market volatility had no impact on how they invest in ETFs.”

In essence, Botset said, the ETF industry’s ongoing efforts to educate investors on how to avoid knee-jerk reactions and risky tactical moves appears to be taking hold.

Nate Geraci, president of The ETF Store, cited the finding that 41% of non-ETF investors expect to purchase an ETF in the next two years as “the most noteworthy data point.”

“That’s a massive number,” he said. “Combine that with robust interest from younger investors, and it’s clear the future for ETFs is extremely bright.”

But even while the future looks bright for ETFs, which now come in just about any stripe or flavor one can imagine, and while the wrappers continue to gobble share from mutual funds that are trying to compete by slowly lowering fees, there is always a new threat in financial services.

That brings us to direct indexing, which the asset management industry has been pushing as the next big deal for financial advisers and their clients.

Schwab’s report describes the personalization afforded through direct indexing as “the next frontier,” and claims 46% of ETF investors are interested in learning more.

“There’s no question that interest in direct indexing is increasing, though assets haven’t exactly equaled the hype,” said Geraci. “Direct indexing is fighting against three major trends that took hold over the past decade-plus and still appear intact: a shift from active to passive management, a move from higher-cost to lower-cost investments, and a preference for simplicity over complexity.”

Balchunas, who self-identifies as the “most bearish person on my team” when it comes to direct indexing, suggests that “Schwab is smoking the hopium” regarding direct indexing.

“I think direct indexing has been grossly overhyped and overestimated,” he said. “I can see why the industry wants it to succeed because it’s more money for the industry. But ETFs are fast, good and cheap. I’m just bearish on anything trying to dislodge a frictionless, total-market-exposure ETF for 3 basis points.”