Thank you Mr. Rabner for a timely, thoughtful and thought provoking article on direct indexing. You highlight well the assumptions underlying direct indexing, in particular the inconsistency of an approach marketed as ‘passive’ but which uses investors’ armchair analyses (“this sector/stock should outperform or underperform…”), or their morals or values (personal preference) to screen holdings. As you note, this is either active management or behavioural finance dressed up as indexing. The professionals at Goldman Sachs and JP Morgan, who have more tools, training and resources than retail investors, are more likely to accrue any available alpha than are direct indexers, who end up with a sub-optimal beta.

The finance industry’s sleight of hand regarding the underlying premise of direct indexing has parallels in ESG investing, where morally dubious (e.g. high carbon footprint) securities or sectors are screened out of portfolios. Some institutional investors subsequently employ a custom benchmark against which to measure their screened portfolio. Of course the custom benchmark falls below the efficient frontier and the screened securities are just in another investor’s portfolio (it’s called a secondary market for a reason :) As Mr. Rabner shows in his direct indexing examples, equating ESG screened portfolios with outperformance (and positive impact sue to removal of the offending securities) is based on a flawed heuristic. Visible examples abound from university based champions of divestiture who write opinion pieces highlighting their moral victory and then champion their anticipated investment outperformance. As when direct indexers invest according to their preferences, the ESG divestment crowd has far less insight on valuation than do Goldman Sachs or JP Morgan.

While direct indexing and morals-based ESG screening may not be entirely consistent with modern portfolio theory, they do share a benefit grounded in behavioural finance. As Meir Statman has shown, there can be a genuine non-financial benefit to investors from holding an investment portfolio that resonates with one’s morals or values or investment outlook, even if it is sub-optimal from a Markowitz efficient frontier perspective. A truly bespoke direct indexed portfolio likely offers better alignment and greater ‘satisfaction’ than a generic screened index or mutual fund. The question for direct indexers is ‘at what cost’? The first cost is the suboptimal risk/adjusted return, which in practice may not be large (depends upon the size and correlation of the divested securities). The second is the fees which, as Mr. Rabner highlights are at least lower with direct indexing than with traditional active management.

Pension funds and other fiduciaries have an additional consideration which is whether an approach is in the interest of their beneficiaries. On this they continue to differ in their conclusions. Some institutions divest whole sectors from their ‘universal owner’ portfolios and then cite anticipated outperformance and/or other collateral benefits to beneficiaries, while others maintain a fully diversified portfolio and engage with the companies their peers have divested from. The recent ExxonMobil proxy battle provides an interesting example, after which Anne Simpson of CalPERS’ noted that all four rather than just three directors from the dissident slate would have been elected if divested institutions had retained their shares (no shares; no votes).

I’ve diverged a bit from Mr. Rabner’s point (that’s the ‘thought provoking’ part of his article…). Direct indexing is an area of growth for investment managers to be sure - who wouldn’t want their old-school, high priced brokerage model replaced by a lower-cost (automated) and more tax efficient new model - and, while not as good as traditional indexing, perhaps a better solution for many than traditional active management.