ETF pioneer Grossman urges asset managers to adopt direct indexing

One of the pioneers of exchange traded funds said traditional asset managers must embrace innovations such as simple bespoke portfolios and give up on a “fantasy land” belief in a comeback for active fund management.

Blake Grossman worked at Barclays Global Investors for more than two decades, helping build a powerhouse in exchange traded funds known as iShares, where he served as chief executive from 2002. When BlackRock bought BGI, including iShares, in 2009, Grossman became a vice-chair, until he left the asset manager in 2011.

Now a managing partner at fintech venture capital firm ThirdStream Partners, he said many asset managers were living in the past.

“Outside of a few firms, the asset management industry has been resistant to change and embracing technology and innovation,” Grossman told the Financial Times. “Hope springs eternal that a new era of fundamental active management outperformance will return. It’s fantasy land.”

Direct indexing — a form of bespoke off-the-shelf investment that has been a niche for the ultra-wealthy — is the latest trend to challenge asset managers.

It allows investors to own a group of stocks that mimics the performance of an established index while managing tax losses and customising around, for example, environmentally-conscious goals to form personalised portfolios.

Grossman said established investment houses must adapt to the phenomenon. “A lot of assets are tied up in traditional, actively managed and underperforming strategies that should be invested elsewhere,” he said. Asset managers should “develop a direct indexing presence, or outsource that capability”, he added.

During the past year, Vanguard, JPMorgan, BlackRock and Morgan Stanley have bought companies involved in direct indexing, which is gaining a wider audience thanks to vanishing trading costs and the ability to own fractional shares of expensive stocks. This enables financial advisers to create portfolios quickly and update them continuously for clients.  

“The cost and complexity of doing this before was very high, and now technology is making this approach available to more investors,” said Grossman. “Custom indexing will be a core part of how investing looks in the future. It will reflect personal themes and the values of investors and will also reflect their tax situations more efficiently than a mutual fund or an ETF.”

In a recent report, Cerulli Associates said it expected direct indexing to grow at an annualised rate of more than 12 per cent over the next five years, from total assets of $362bn at the end of 2020. The consulting firm also projected direct indexing to eclipse the pace of expansion for mutual funds and ETFs and other traditional financial products.

“Asset managers are acquiring direct indexing providers, introducing proprietary solutions to market, and applying direct indexing to new asset classes,” said Tom O’Shea, director of managed accounts at Cerulli. “Unlike mutual funds or ETFs, direct indexing provides individual portfolios with greater control to harvest gains and losses at the individual security level, while staying in risk and tracking error bands.”

Mutual funds and ETFs will remain an important part of the portfolio mix for many investors, Grossman said. But he added: “A significant percentage of what is in index mutual funds and ETFs can be productively converted into custom portfolios. Over time, this is not just 5 or 10 per cent.”

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