Direct Indexing Drumbeat Continues with Morningstar Adviser Offering

Morningstar is the latest entrant to tout a direct indexing option for financial advisers, allowing them to invest directly in the underlying stock of indices to offer benefits such as tax advantages.

Morningstar Inc. on Tuesday became the next financial services firm to announce a direct indexing option for advisers to provide more personalized investing to clients with potential tax advantages.

Morningstar’s newly created wealth group will offer Morningstar Direct Indexing to advisers with the goal of providing the trending investment strategy at scale, the Chicago-based firm said in a statement. The capability is being made available after a “council of advisers” piloted the program for almost a year.

Morningstar’s launch adds to a trend in direct indexing, which allows for more personalization by investors purchasing the underlying stocks within a particular index and then catering it for tax advantages or investing preferences, such as incorporating environmental, social, and governance (ESG) objectives.

“Advisers are looking for ways to meet client interest in new investment options, particularly those that allow customization and personalization,” said Daniel Needham, president, Morningstar Wealth. “Morningstar Direct Indexing leverages the strengths of Morningstar to allow advisers the ability to engage in new and collaborative ways with their clients.”

More than 42% of wealth management firms now offer direct indexing strategies, according to an October survey by F2 Strategy, noting that the biggest reason for implementation is tax savings. Other reasons include catering for ESG, or simply FOMO – fear of missing out – on certain stocks.

Morningstar noted in the announcement the use of “tax-loss harvesting” through its offering. This is a strategy by which an investor can sell positions that “are down–’harvesting’ or recognizing the losses–and using those losses to offset capital gains from other positions,” according to a September Morgan Stanley report.

Just last week, Fidelity announced a direct index offering for its separately-managed accounts (SMAs) lineup available for wealth management firms and institutions. The Boston-based financial services firm also noted the offering’s ability to customize investments, with plans to make it available next year for registered investment advisers, broker/dealers, and family offices.

Money manager Black Rock Inc. entered the space in November 2020 with the acquisition of Aperio. They were followed a year later by New York-based Morgan Stanley when it acquired Parametric Portfolio Associates LLC through the purchase of asset manager Eaton Vance, and soon after that investment manager Vanguard entered the space by acquiring Just Invest.

Interest Growing, Quality Lagging

The F2 Strategy survey, which polled 33 RIA, wealth management, and asset management firms in August and September noted that of firms engaged in direct indexing, 71% used a third-party tool to help them manage their strategies. Overall, firms did not give high scores to the technology and support available for direct indexing, the San Francisco-based F2 said.

“Firms have a wealth of technology options to support direct indexing; however, they say many don’t fully address their most important functionality needs,” the report said.

While direct indexing is similar to SMAs in terms of personalization, it can offer even better tax optimization “to a broader set of clients,” according to a recent report from Cerulli Associates. The Boston-based research firm notes that “the disappearance of brokerage commissions, use of fractional shares, and ever-increasing sophistication of algorithmic portfolio construction techniques” makes the more catered investing possible.

Morningstar said its offering is driven by its in-house investment management, indexing, and research divisions to create and manage the investments at scale for advisers and advisement firms.

Morningstar Direct Indexing is one of the first product launches from Morningstar Wealth, which launched in February. The group plans to announce additional offerings to advisers and firms over the coming year, the statement said.