Separately managed accounts, customized model portfolios in a wrap-fee account, were for years the favored tool of advisors for wealthy clients.
But there are limitations. Buying and selling whole shares, with high commission and trading costs, make them expensive portfolios to maintain and cost-prohibitive for the mass affluent, who must “make due” with mutual funds or exchange traded funds.
But just like other products for institutions and high-net-worth investors, the concept has moved downstream. The new technology—direct indexing—makes it possible to replicate the best of both separately managed accounts and indexed-based funds. Advisors can build cheap, customizable portfolios for clients based on indexes or model portfolios, using fractional shares of stocks, automatically rebalanced, with lower transaction costs.
That can bring tax-loss harvesting to indexed portfolios, or cheap rules-based portfolios that can be customized to accommodate a client’s legacy investments without changing the risk profile.
Some robo advisors—Wealthfront being the first—already offer direct indexing to clients, while many wealthtech firms are building the tools for financial advisors.
“I think the potential for this technology is substantial,” says Michael Kitces, publisher of the Nerd’s Eye View blog and partner and director of wealth management at Pinnacle Advisory Group. “The more that the technology scales, and the lower trading costs and asset-based wrap fees become, the more feasible the strategy becomes.”
“I think if you forecast forward 10 years and think about what could be the new hot way people get access to the markets, direct indexing is probably the best post-ETF answer,” says Matt Hougan, CEO of Inside ETFs (Inside ETFs and WealthManagement.com are both owned by Informa Plc.)
“It’s the most exciting thing we are working on,” said Eric Clarke, CEO of Orion Advisor Services, at the recent MarketCounsel Summit in Miami. In March, Orion will unveil their direct-indexing tool, dubbed “Project Astro,” for “Advisor Strategy, Tax-Return Optimization.”
“Most clients have some type of legacy position. Advisors would spend hours creating custom portfolios around them. The optimizer will allow them to do that in seconds,” producing a portfolio that matches the risk characteristics of the underlying index or model. “The math is formidable,” Clarke said, but the technology is here.
One of the big advantages to direct indexing is tax-loss harvesting. While index funds and ETFs are legally prohibited from passing on tax losses to investors, individuals can harvest losses on individual securities via direct indexing. Wealthfront estimates this could boost returns by 2.15 to 2.66 percent.
Direct indexing also lets an investor “tweak” a low-cost, index-based portfolio around a client’s individual environmental, social or governance values, like buying an index fund, but stripping out the individual companies that score low on labor practices or water consumption. ESG mutual funds or ETFs don’t allow for customization—the values are those of the portfolio manager or index committee, which may or may not align with the investors.
The Rise of Direct Indexing
Active Index Advisors, now a unit of Natixis Investment Managers, started offering index-based separate accounts in 2002. The firm’s founder, Kevin Carter, developed one of the first fractional share/dollar-based investing platforms, which he sold to E*Trade.
Economist Burton Malkiel was involved with the original inception of Active Index Advisors, and many of the ideas there stemmed from him. In 2012, he joined Wealthfront as chief investment officer, and in 2013, that company rolled out its direct-indexing platform for clients with $100,000 or more.
Active Index Advisors meanwhile remains largely focused on retail financial advisors. They build individual index-like portfolios, typically with about 150 stocks, designed to track an index before taxes, but outperform on an after-tax basis through the loss harvesting process, says Kevin Maeda, chief investment officer.
“With direct indexing, if you own the stocks directly, if you own Amazon and Google and other stocks directly, if any of those happen to fall in value you are allowed to sell those off, recognize the loss, and for an individual, that now provides, or could provide, much greater tax benefits than if they were in an indexed mutual fund or an ETF,” Maeda says.
Active Index Advisors is not the only firm bringing direct indexing to the wealth management space. SMArtX Advisory Solutions, which grew out of Hedgecovest, is a turnkey asset management platform catering to RIAs and also manages the fully integrated UMA solution for SS&C Advent clients. The platform provides direct indexing strategies through a UMA/SMA structure, letting investors skip over the ETF product providers and go right into the index.
Several index providers, including FTSE and BRI Partners, are signing on to work with SMArtX to make their products available on their platform. They charge a total of 15 basis points. SMArtX CEO Evan Rapoport believes this could cut out the structured product.
The index providers are getting the margin expansion, he said. Instead of charging, say, 2 basis points in a licensing fee to the ETF provider, they can charge more with direct access to the client, he said.
“One of the advantages of direct indexing is that the index provider does not have to go create an ETF, and spend $300,000 to fund it, to get it up and running,” says Stephen Scott, partner at BRI Partners.
The advent of fractional shares and the technology behind it has propelled direct indexing. Apex Clearing, the custodian to many of the robo advisors, was an early mover, with technology allowing investments in small fractions of a single stock, as small as one hundred-thousandth of a share, the firm says.
“Fractional shares enable you to get that full index exposure for way less than you would normally otherwise,” says Sam McIngvale, head of retail innovation at Apex. “But we have customers that for as little as $100 or maybe $500, are giving their customers a direct indexing strategy that’s giving them broad exposure across tens, if not 100s, of names.”
Aside from the tax benefits, another advantage of direct indexing is the ability to customize a stock portfolio, something that could differentiate a financial advisory firm in a competitive environment.
M1 Finance has an investing platform that allows customers to build their own portfolio using any public stock or ETF. The company has a $100 minimum and charges 25 bps per year on accounts with $1,000 to $100,000, as of Dec. 4.
“For the client it’s really hard to justify paying an advisor 1 percent, or 1 percent and a quarter, whatever it may be, to just own the same eight funds that everybody else owns,” says Brian Barnes, CEO of M1 (and son of former Sara Lee CEO Brenda Barnes). “I think that there’s a want to move beyond the generic, and then there’s also a want to put your money towards things you care about or believe in. Now it’s just far more cost effective to do that.”
Inside ETFs’ Hougan believes direct indexing could solve the problem of traditional environmental, social and governance investing, which doesn’t allow any real customization.
“If you believe all the statistics that 80 percent of investors want to put an ESG sleeve on their portfolio—and as the generational wealth transfer happens and more wealth is controlled by Gen-X’ers and below, that ESG is going to rise—the best way for it to rise in many aspects is in a direct indexing context where I can customize that portfolio to meet my precise view of what matters in society,” he argues.
So, if a person doesn’t like gun stocks or companies that don’t have any women on their boards, they can exclude those.
“If someone said, ‘I would love to have an S&P 500 portfolio, but please exclude all technology, smoking tobacco, alcohol and these five random companies,’ you couldn’t buy that off the shelf,” Maeda says. “But you can with us. That would be completely customized to screen out whatever you did not want, and we’d simply work around the rest of the positions. So it’s fully customizable based on your personal beliefs, or your situation, for both risk purposes, social purposes, or whatever the case may be.”
This customization also comes in handy for clients with concentrated stock positions. If a client works at Google or another company and a lot of their wealth is tied up in that one stock, that’s a financial risk, Maeda adds.
“If it’s a technology stock, we could build a portfolio that excludes all other technology stocks and that way it would provide them with better diversification,” he says.
“Now advisors like this as well because it creates a way for them to prospect new clients and earn more revenue on something that before was untouchable,” he said. “So if they went out to clients who had a concentrated stock position, there’s really nothing they can do for them historically. Now they can offer them a strategy that will either help to diversify around those positions to help reduce some of their risk, or to help transition out of those positions and turn all those assets into revenue generating assets for the advisors.”
Direct indexing also allows an advisor to more carefully diversify and craft a portfolio that meets clients’ specific objectives because there’s more transparency into what is owned, SMArtX’s Rapoport says.
If an advisor puts together a portfolio of several ETFs, “they have little understanding of how many of the same stocks are owned in the different ETFs,” Scott says. The advisor can only do the correlation analysis and risk management at the ETF level.
“By owning true direct indexing, you’re now able to do true portfolio risk management and correlation analysis, etc., at the individual security level,” he says. “That can be very important, especially in times of market stress when correlations are rising.”
“I would argue we are cresting the hill where [direct indexing] technology is going to cascade into the rest of the industry,” McIngvale says. “Over the next 24 months, you will see many more traditional wealth managers and advisors rolling out direct indexing strategies.”