Technology has lowered barriers to direct indexing, allowing U.S. firms to offer the service to more clients looking for tax opportunities and personalized investments. But Canadian investors may be less keen on the potential competitor to ETFs.

Direct indexing allows investors to track an index by owning the underlying securities in a separately managed account (SMA) rather than through an ETF or mutual fund. Owning the securities directly allows for tax-loss harvesting and to remove certain firms from an index.

In the past, firms offered direct indexing services to high-net-worth (HNW) investors only. However, the ability to automate tax-loss harvesting strategies and the rise of fractional share and no-commission trading has allowed firms to broaden access.

Earlier this year, Boston-based Fidelity Investments Inc. introduced a line of direct indexing products available to investors with as little as US $5,000. Morgan Stanley, Goldman Sachs Group Inc., BlackRock Inc., The Vanguard Group Inc. and Charles Schwab Corp. have also bet on direct indexing, either by acquiring direct indexing providers or developing capabilities in-house.

Jennifer Sireklove, managing director of investment strategy with Parametric Portfolio Associates LLC in Seattle, said the “bread and butter” appeal of direct indexing is tax efficiency. Parametric, which offers customized SMAs to clients with investable assets of at least US $250,000, managed more than US $160 billion of direct indexing assets as of July 31.

“That can be the active tax-loss harvesting — not having to liquidate assets to bring them into the account,” she said. “You can bring them in ‘in kind,’ you can gift some out, you can work around those concentrated positions.”

Sireklove said these strategies could add up to 2% in after-tax returns for the client, not including advisor fees and management costs.

For investors at lower asset levels, where the tax savings are not as pronounced in real dollar terms, direct indexing’s primary appeal is removing firms from the index, said Daniel Straus, director of ETF strategy and research with National Bank Financial Inc. in Toronto. Many ESG ETFs have mandates that may not align with an investor’s personal priorities, he said.

Direct indexing could also be “extremely practical” for wealthy clients who want exposure to a broad index but want to remove a company in which they already hold a big position, said Mary Hagerman, portfolio manager with Raymond James Ltd. in Montreal. If these clients were to buy an index ETF, they would own even more of the same stock.

However, the opportunity to customize must be weighed against the risk associated with turning a passive index strategy into active management.

“The more you start picking apart the ETF for reasons related to alpha, the greater the probability that you end up with a tracking error or a return that looks nothing like the index. And the index return just might be a lot better in many cases,” Hagerman said.

While direct indexing will grow in popularity, experts said ETFs should have staying power because of their low cost and ease of use. Direct indexing management fees tend to fall in the 0.25% – 0.40% range, while some broad-based index ETFs in Canada charge less than 0.15%. “It’s almost impossible for me to envision how the appeal of [big index ETFs] can be dislodged by direct indexing,” Straus said.

Parametric said its plans to launch a “tax-managed relationship” with a Canadian-based advisor retail platform were put on hold after parent company Eaton Vance Corp. was acquired by Morgan Stanley in 2021.

For their part, Canadian wealth firms haven’t introduced direct indexing products. One reason may be that tax-harvesting opportunities for direct indexing are muted in Canada as compared to the U.S., where each security’s individual cost base is tracked under what’s known as “tax lot accounting.” Under Canadian tax rules, multiple purchases of the same security result in an adjusted cost base across all units of the same security.

In addition, Canadian firms and investors tend to be more conservative when adopting new investment strategies, said Dan Hallett, vice-president and principal with Oakville, Ont.-based HighView Asset Management Ltd.

“The U.S. is just a bigger, more mature market,” he said. “I don’t think there has been any real [client] demand for it.”

But Daniel Gonzalez, research analyst and consultant in Toronto with California-based Javelin Strategy & Research, thinks demand for direct indexing in Canada will increase in the coming years, driven by millennial clients. “Younger investors enjoy the DIY approach,” he said.