By Vijay Vaidyanathan
"This is the next $100 billion advisor opportunity," declared Matt Hougan, Inside ETFs chairman, at Inside ETFs' February 2019 conference. Hougan was referring to direct indexing, which has started to take the financial advisory industry by storm. Big institutional players have traditionally directly invested in stocks, rather than wrapped products such as funds and ETFs. Now, as a result of technological advances, directly investing in stocks, aka “direct indexing” is coming to Main Street.
Financial advisors who haven't entered the direct-indexing space yet are falling behind the curve as many experts such as Hougan consider it the next step in the evolution of stock investing. Direct indexing enables investors to take advantage of unparalleled customization and tax management practices, such as stock level tax-loss harvesting and capital gains tax deferral, that have heretofore been unavailable to individual investors.
It's a natural evolution: ETF dominance is over; direct indexing is rising
Over the past decade, it has been easy to consider ETFs as the unstoppable champions of the investing world. Like all champions, ETFs possessed something special that put them in a class by themselves. They did it by improving upon their cousins, the mutual funds.
Prior to ETFs, mutual funds allowed individual investors to finally diversify without spending enormous sums of time and money acquiring individual securities.
ETFs improved on mutual funds. Rather than needing to pay expensive loads and meet fund minimums, investors could buy an index or other types of ETFs just like a stock. ETF shares can be traded intraday, and investors can employ margin. Finally, the ETF eliminated the obscure capital gains distributions that burdened the long-term mutual fund investor.
ETFs also provide variety, offering everything from index funds to funds that trade commodities and forex. With a few smart ETF plays, investors of modest means can gain wide diversification. It's no wonder that, since 2009, mutual funds have suffered $92 billion in outflows while ETFs gained $2.3 trillion in new investment.
ETFs disrupted mutual funds by offering something a little bit better. Now ETFs face disruption because direct indexing offers several new features that make them much better.
What direct indexing offers
During the Inside ETFs Conference, ETF.com CEO Dave Nadig explained that to get to and through retirement, clients need a new mode of transportation—one where client's values and circumstances count because the portfolio is designed just for them.
He said, "ETFs are pretty good transport—tax-efficient, low costs, etc.—but they aren't perfect. They are not tax maximized; trading is not always good, as the late John Bogle has said." Direct indexing offers the advantages of ETFs but allows the investor to add or strike certain investments.
For example, if an investor likes a certain portfolio but would rather see a specific stock eliminated (or added), the advisor can accommodate this request. The customization can be broader, such as eliminating or adding investments in certain countries or sectors.
Advisors create their clients’ preferred index implementations in a separately managed account. Additionally, advisors can use direct indexing to assist clients with tax planning. Tax-loss harvesting provides a tried-and-true method of enhancing after-tax portfolio returns.
Also known as "tax-loss selling," tax-loss harvesting harvests losses to offset capital gains. The securities sold at a loss can then be replaced by a similar asset. If the investor selects an appropriate similar asset, his or her portfolio remains largely unchanged, except for the tax benefits. To truly capture the benefits of this strategy requires the flexibility and customization of stock-level investing, or direct indexing.
The party is just starting
"We do not see ETFs going away," Hougan said during the Inside ETFs conference. ETFs have carved out their place, but advisors who offer investing opportunities in both ETFs and direct indexing will be ahead of the competition.
Considering the projected $100 billion opportunity direct indexing could provide, financial advisors who offer direct indexing stand to gain new clients. Since direct indexing is fairly new, it provides an ideal opportunity for advisors to expand their client base by educating the public. When investors hear about the ability to essentially have a customizable ETF with tax benefits, excitement is inevitable. Advisors will win clients when they show how direct indexing can be used to achieve their personal financial goals.
Advisors also create a stronger practice with their existing clients by introducing them to direct indexing. The customization provided by direct indexing products allows investors to own a product as diversified as an ETF, but they can also include or exclude certain investments.
For example, a client might prefer to remove a stock they already hold in their employee stock plan. Clients come to understand that they have control of the portfolio; they can make changes without having to make a decision to buy or sell the entire fund. Finally, advisors can demonstrate the increases in returns that result from tax harvesting and capital gains deferral.
Direct investing allows financial advisors to go beyond goal-based investing as a planning tool, and use it as a tool to actually shape the outcomes that each client’s goals require. They can confidently ask clients what they need the money for, how much will they need and when they will need it by. With direct-index investing, the advisor knows that a customized solution to shape the investment outcomes to achieve those goals can be easily created.
The excitement around direct indexing shows its power to become the next $100 billion financial advisor opportunity. It provides all the benefits of ETFs while removing the straitjacket of standardized portfolios with a mass customization solution. As CDs gave way to iPods and flip phones were replaced with smartphones, so innovations drive the natural evolution of markets. For investment advisors, direct-indexing innovation provides a hot new product that clients love.
Vijay Vaidyanathan, Ph.D., is CEO of Optimal Asset Management, an SEC-registered investment advisor specializing in the delivery of institutional-grade investment solutions for all investors.