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Fintech Investment strategies


THE RISE OF DIRECT INDEXING

By  Ryan W. Neal
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March 09, 2022, 8:09 p.m. EST 10 Min Read
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In 1992, a large family office approached a boutique asset manager based in
Seattle for help with an investing challenge. The client was tired of the
vagaries of asset management and wanted a portfolio that behaved like an index
but with more after-tax considerations than traditional passive strategies allow
for.

The answer was a custom-built portfolio that, instead of consisting of ETFs or
mutual funds, directly purchased the hundreds of securities those funds contain.
This allowed the portfolio to passively track a benchmark specified by the
client, but also let the portfolio managers sell individual stocks at a loss to
offset capital gains taxes.

That portfolio was one of the inspirations for direct indexing, a strategy that
has powered Parametric — that Seattle-based boutique — to $428 billion in assets
under management over 30 years. Eaton Vance acquired Parametric in 2003, and in
November 2020, Morgan Stanley bought Eaton Vance, in no small part to bring
Parametric’s direct indexing capabilities in-house.




“It took a long time for the idea that you should be cognizant of, and managing
for, after-tax portfolio performance to take root beyond just the most
cutting-edge, UHNW advisory community,” said Brian Langstraat, who began at
Parametric in 1990 as a portfolio manager before taking over as CEO in 2001.
“More interest in this space is good for the investors and good for Parametric.
We’ll do less evangelizing and less missionary work, and more investing and
creating portfolios for advisors and clients.”

The Morgan Stanley deal was just one of a dozen recent examples of financial
institutions buying into direct indexing, which has exploded into mainstream
wealth management after being a tool exclusively for ultrahigh net worth
investors. Just weeks after the Eaton Vance acquisition, BlackRock picked up
Aperio. Even ETF stalwart Vanguard made its first acquisition in company history
to pick up direct indexing fintech Just Invest in October 2021.

Charles Schwab, Goldman Sachs, CI Financial, J.P. Morgan, Franklin Templeton,
Prudential Global Investment Management, Pershing and UBS have all bought in.
Meanwhile, Fidelity Investments is beta testing a new product that will provide
direct indexing to retail investors for just a $5,000 minimum.

After operating in relative obscurity for 30 years, direct indexing suddenly
became table stakes for financial institutions, which expect product
customization to power the next generation of growth. Even if built
automatically, direct indexing technology gives firms the ability to say they
can give every customer, regardless of asset size, a custom portfolio tailored
to their exact specifications.



The assets are following. Direct indexing claimed $362 billion in 2020, nearly
one-fifth of the total retail separate account assets, according to a report by
Cerulli and Parametric. Assets in direct indexing are expected to grow at an
annualized rate of more than 12% over the next five years, outpacing traditional
products like ETFs and mutual funds. They should cross the $1 trillion threshold
by 2025, according to the report.

“That blew my socks off,” said Tom O’Shea, research director for managed
accounts at Cerulli Associates. “It’s been a millionaire’s product from the very
beginning … now it’s in the hands of the mass investor.”

High costs meant high minimums
To understand direct indexing’s sudden explosion into the mainstream, it’s worth
looking at why it remained on the margins of wealth management for so long.

To start, there were no tools to manage the tradeoffs between passive
portfolios, tracking error (the divergence between the portfolio’s behavior and
the benchmark) and taxes. Managing hundreds of equities in a single portfolio
required a lot of work.

“A lot of it was done in spreadsheets. There weren’t a lot of accounting systems
that would successfully track tax losses,” Langstraat said. “There was a time
when I would go make the client pitch, I would facilitate the signing of the
contract, open the account at the custodian and build the portfolio, build the
reports and deliver the client meeting.”

With few people even talking about direct indexing in the 1990s, firms like
Parametric and Aperio had to conduct and publish their own research while also
developing risk models and early versions of technology. There was a lot of
networking to figure out which tools could be adapted and which had to be built
from scratch.

“Six years ago, a lot of advisors weren’t necessarily aware of this and didn’t
always have access to it or an understanding of all the benefits,” said Monali
Vora, head of direct indexing and custom equity at Goldman Sachs Asset
Management.

It was also expensive — very expensive. Mimicking an index requires holding at
least 250 securities, which requires a sizable minimum investment.



“In order to get an S&P 500 index that allowed for tax management, you had to
have at least $250,000 to $500,000, and that’s just your core exposure,” said
O’Shea. “For your whole portfolio, you would need to have about $2 million, at
least.”

The high minimums and heavy workload meant the strategy really only made sense
for the wealthiest of clients — usually those with $10 million or more to invest
— and the small number of advisors who served them.

Industry trends knocking down barriers
Several industry trends over the last decade have knocked down those barriers to
entry.

Digital innovation is arguably the biggest factor. New trading engines make it
much easier to quickly buy hundreds of shares and automate tasks like
rebalancing and tax-loss harvesting.

There’s also what Dennis Gallant, a strategic advisor for Aite-Novarica’s wealth
management practice, called “the Robinhood effect.” The trading app popularized
fractional-share trading, which allows investors to buy pieces of expensive
stocks such as Apple and Amazon. Robinhood also featured zero-commission
trading, which quickly put pressure on other online brokerages to follow suit.
In 2019, nearly every online brokerage had dropped commissions from
self-directed trading.

Both innovations helped to reduce investment minimums. Without needing to pay
full price for exposure to blue-chip equities, investors could directly own most
or all of the underlying shares in the S&P 500 with a much smaller investment.
And without having to pay commissions for every trade, an automated system could
constantly search for tax-loss harvesting opportunities without worrying about
cost offsetting the tax alpha.

Goldman, for example, has been able to reduce the minimum on its direct indexing
service from $10 million to $250,000, said Vora.

“That’s something that I personally spent a lot of time on,” she said. “Taking
that UHNW solution and democratizing it.”

Changing attitudes about passive investing and an embrace of the algorithmically
created portfolios popularized by robo advisors have fostered an environment
where direct indexing makes sense for more advisors.

“There’s a changing perception of what investing for private wealth should be
and how advisors focused on private wealth should act,” said Langstraat.
“Advisors are moving away from stock selection to [concentrate on] asset
allocation and financial planning.”

Limitations
There are some who remain skeptical about just how far down market direct
indexing can come.

Offering the strategy at scale still entails a great deal of complexity. Owning
several hundred stocks raises questions about proxy voting and quarterly reports
the size of Russian novels. The benefits of direct indexing — customization and
tax-loss harvesting — require sacrificing the simplicity of buying a single,
low-cost ETF. That’s an easy trade-off for HNW clients, but the benefit might
not justify higher premiums for smaller investors.

“They go from getting a six-page statement to a 100-page statement and endless
1099s at the end of the year — maybe not in line with what the client is
expecting. Is it worth all of that additional complexity?” said Derek Hernquist,
head of advisor experience at Aptus Capital Advisors, a $3 billion asset
manager.

Hernquist also wonders if thematic investing built with direct indexing could
end up limiting portfolio diversification for retail investors.

“When you get to the direct-to-consumer market, the concern is you end up with
some clients who jump on certain themes and misread owning a bunch of names as
having diversification when they don’t,” Hernquist said. “[Direct indexing]
loses all benefits if it becomes concentrated in a specific center. You might as
well just own an ETF.”

There could also be complications with onboarding clients and helping them
understand how the solution differentiates from other products, such as a
lower-cost robo advisor. Advisors will also need to be trained on the benefits
of direct indexing and why it’s worth adopting a new system.



“It’s asking advisors and investors to think about their equity investments in a
different way,” said Vora.

On the technology front, firms must ensure that trading systems are efficient
and effective so direct indexing doesn’t end up costing more than anticipated,
Gallant said.

“You’re taking a product that has been very much built for the smaller, HNW
market,” Gallant said. “If you open it up to a broader audience, the volume of
customization can be astounding.”

Producing quantitative data on ESG impact and tax optimization can be easier
said than done, said Michael Daly, a senior consultant with Capco, a business
and technology management consultancy firm with a focus on financial services.
So is building it into a user-friendly application that supports client and
advisor interactions.

The data behind ESG rankings: How to make investment decisions backed by numbers
February 15, 2022 2:33 PM

The winners in the space are going to be companies who successfully use direct
indexing to align a portfolio with investors’ values and preferences,
successfully communicate the tax alpha added and avoid an overly complicated
digital user experience, said Robert Norris, a managing partner at Capco.

Why companies are buying in
The key driver behind the sudden interest in direct indexing is a widespread
belief that customization will be a key driver across wealth and asset
management over the next decade, even more so than alternative investments and
digital securities.

The rising popularity of ESG investing over the previous decade also created
demand for more customization in passive strategies than can be offered in
classic ETF portfolios. Rather than build a portfolio of ESG-specific funds, an
advisor can use direct indexing to remove companies a client objects to from an
index (and even replace it with something else to reduce tracking error). Or,
advisors can customize portfolios for clients overweighted in certain positions
from a self-directed brokerage account or their employer’s stock.

“[Clients] want much more tailored and specific investing,” said Scott Reddel,
who leads Accenture’s wealth management practice in North America. “I’ve heard
wealth management firms talk about ... the degree we can tailor investments to
match your financial plan at the atomic security level.”

Norris added: “Advisory firms are looking [at direct indexing] and saying, ‘I
can be even more customized, more personalized, but for the same level of cost
and effort,” Norris added.

While direct indexing may be a difficult concept to explain, advisors could find
that telling clients which specific companies they are invested in may be more
engaging than just giving them a list of ETF tickers — especially for those who
began investing on self-directed apps.

“You not only have control of your money, you know how money is being invested,”
said Norris. “It’s not just in some black box, S&P 500 fund.”

Where is this going?
While nearly all direct indexing AUM has been with boutique asset management
like Parametric and Aperio, new products for advisors and retail consumers could
start a shift.

“I’ve heard three years; I’ve heard five years; I’ve heard 10 years for direct
indexing to really establish itself in the market,” said Gallant. “The next
generation of the direct indexing world really starts later this year.”

However, Fidelity’s launch of Managed FidFolios could significantly crunch the
timeline. Though no one expects direct indexing to create substantial outflows
from ETFs anytime soon — direct indexing isn’t very useful for tax-advantaged
retirement accounts — all eyes are on how the brokerage’s direct-to-consumer
product resonates with the retail market.

While not everyone is certain it will resonate among mass market investors, few
doubt the opportunity to continue expanding direct indexing to more investors.

“This is the year we’re going to start seeing the products roll out,” said
Gallant. “This is just the start of the wave — just the foundation. If consumers
really eat this up and start to go in, who knows where it will go?”

Ryan W. Neal
Technology Editor, Financial Planning
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