Direct indexing expands into Canada with new offering from Envestnet

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Advisors in Canada are getting a sense of what the direct indexing trend that’s grown significantly in the U.S. is all about with a new offering for unified managed accounts from Berwyn, Pa.-based financial technology firm Envestnet Inc.

This new tool may be appealing for advisors with high-net-worth clients who are looking for ways to differentiate their business, allow more customization in client portfolios and offer the benefits of tax-loss harvesting.

Direct indexing aims to track a specific index, such as the S&P 500, not by investing in a pooled account, such as an exchange-traded fund, but by purchasing the individual stocks in the index instead, sometimes between 150 to 200 names. That allows advisors to customize the investment to the needs and desires of their clients and sell stocks when required to offset capital gains in their clients’ accounts.

For example, a client can invest in the S&P 500 index through a direct indexing product that holds only some of the stocks listed on the index while aiming to mimic the index’s performance. They can customize the direct indexing product by excluding firearm or fossil fuel companies, for example, and can sell individual stocks when needed for tax-loss harvesting.

If a client just owned an S&P 500 fund, it would own all the stocks in the index and could only sell the whole fund, not any individual part of it.

“With direct indexing, you’re managing the tax side more actively, so doing things such as tax-loss harvesting,” says Michael Manning, research analyst at Boston-based research firm Cerulli Associates Inc. and an author of a report on direct indexing. “So, you’re trying to get more tax alpha and not necessarily investment alpha.”

The strategy works best for clients with portfolios of at least $100,000 who need to offset capital gains, he says.

“You can sell a security and then replace it with a similar security that’s going to behave similarly, but you still get that tax benefit. So, that’s the big advantage there,” he says.

Envestnet’s unit, called QRG Capital Management Inc., has run direct indexing strategies in the U.S. since 2013. The move into Canada made sense because Canadian markets work in similar ways to the U.S., says Brandon Thomas, co-chief investment officer at Envestnet.

Direct indexing in the U.S. has been around for decades, but interest picked up in recent years with assets at the end of 2024 totalling US$864.3-billion, up from US$461.3-billion in 2021, according to a recent Cerulli Associates report.

Despite this growth, “a significant runway for adoption remains” as only 18 per cent of advisors reported using direct indexing strategies in 2024, up from 16 per cent in 2023.

“More than one-quarter of advisors (26 per cent) choose not to use it despite having the strategy available to them, and 12 per cent do not know what direct indexing is,” the report states.

Mr. Manning says interest in direct indexing is “starting to pick up, but there’s still a long way to go, because, truthfully, most people don’t understand it.”

There’s also the complication of the acronyms used: separately managed accounts (SMAs) and unified managed accounts (UMAs).

An SMA is like an “envelope” that holds a portfolio of investments, often of one certain type of asset, such as fixed income or equities, that are packaged up and managed by an asset manager for use by advisors for their clients. An investor could have several SMAs for their investments.

A UMA is like a “basket” that can hold several SMAs or “envelopes” in it, and it allows an advisor to manage a portfolio, as a whole, more easily, as the investments are on one platform with one statement sent to the client, Mr. Thomas says.

Envestnet’s direct indexing strategy is being offered within a UMA.

“Firms are becoming much more interested in the UMA implementation, and that makes it easier for us,” he says, as the regulations related to a UMA platform are more streamlined than for an SMA.

The UMA structure is still relatively new in Canada, he notes.

Having all of a client’s holdings in the UMA allows an advisor to “efficiently trade the account, as opposed to having multiple sleeves in different places,” Mr. Manning explains, and it also helps to co-ordinate tax-loss harvesting.

If the direct indexing product is tracking the S&P 500, for example, Envestnet will purchase from about 150 to 175 stocks on the index.

“We have several constraints and guardrails to make us track the index as closely as possible, even though we only buy a fraction of the stocks in the index,” Mr. Thomas says.

While Envestnet has an array of direct index products in the U.S., it will offer a more limited number in Canada to start, Mr. Thomas says, with seven products. Typically, the account minimum is $100,000, he adds.

Five of the products are versions of Envestnet’s market series passive U.S. stock portfolios, which include its U.S. large-cap core product that tracks the CRSP U.S. Large Cap Index. There will also be a U.S. small-cap and a U.S. all-cap product, as well as an international developed markets American depositary receipts (ADRs) strategy, and an Islamic values strategy that tracks the MSCI USA Islamic Index.

The other two strategies are more focused on Canadian investments. Envestnet has an arrangement with the S&P/TSX Composite Index for a Canadian large-cap core portfolio that tracks the index with 125 Canadian names. Another portfolio will use Canadian Depositary Receipts (CDRs), which will give clients exposure to about 60 of the largest U.S. stocks, such as Apple Inc. and Microsoft Corp., but traded on Canadian markets and in Canadian dollars.

Envestnet’s direct indexing strategies have grown more than 40 per cent annualized over the past five years in terms of the number of client accounts, Mr. Thomas says, and he expects similar growth from the Canadian market.

“We’re in the early innings up there, and we could experience that type of growth in Canada as well. It’s something that we’re excited about.”