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Charles Schwab

Schwab Plans April Debut of 'Personalized Indexing'

Charles Schwab's direct indexing option will start with three indexes, tax management and daily attention, and be available to advisors, the custodian announced.

Charles Schwab plans to launch its much-anticipated direct indexing technology, called Schwab Personalized Indexing, by the end of April, according to the firm. The new feature will be available for both advisors and retail clients.

Schwab has been testing direct indexing—the ability to invest in an underlying index with the ability to "customize" that portfolio based on an individual investor's needs—with employees and affiliates of the firm since September. Many of the piloted features have remained in place, such as the $100,000 account minimum and being meant only for taxable accounts. Schwab is charging a 40-basis-point fee for using the service.

Tax and portfolio management will be provided by Schwab Asset Management. Indices will include the U.S. large cap–based Schwab 1000 Index, the U.S. small cap–based S&P SmallCap 600 Index and the environmental, social and governance–based MSCI KLD 400 Social Index.

For the separately managed accounts, Schwab’s direct indexing option “combines technology and human advice,” said Jalina Kerr, managing director of client experience for Schwab Advisor Services. Schwab’s investment team will monitor client portfolios and tax-loss harvesting opportunities daily.

“Each client account is optimized based on the current holdings and unrealized tax profile,” she said. “The portfolio management team [will be] considering factors such as taxes, risks and tracking error during portfolio construction and daily management.”

For now, it appears Schwab Personalized Indexing will focus on automated tax harvesting on the individual investor's portfolio—tax implications on the accounts can vary per client depending on, say, when an investor makes the investment, size of the portfolio and the timing of withdrawals.

In the announcement, Schwab hinted that further work would be done to bring additional customization for both investors and advisors in the next "12 to 18 months," likely the ability to alter the portfolio based on other outside stock positions held by the investor, or along ESG concerns. For now, advisors and their end clients can exclude up to three stocks per selected index, said Kerr.

Schwab’s own estimates predict direct indexing to be more popular than ETFs, SMAs and mutual funds over the next five years, Kerr added. The firm’s direct indexing option, which launches two years after it purchased Motif Investing’s technology and team in 2020, will provide “personalization at scale,” she said.

Advisors are split over the benefits of direct indexing. Terms like “direct indexing” and “custom indexing” are “just active management in disguise, to charge higher fees than index fund fees,” said Scott Salaske, CEO of Troy, Mich.–based Firstmetric. His firm, with $253 million in assets, according to regulatory filings, uses Schwab as a custodian.

“One of the indexes [Schwab] will be offering is the Schwab 1000 Index,” he explained. “Someone can buy the Schwab 1000 Index ETF at an expense ratio of 0.05% or pay Schwab through the new ‘Personalized Indexing’ platform 0.40%—for the same index exposure—just for the privilege of owning shares of the actual underlying securities that make up the index.”

Proponents point to direct indexing’s possible tax advantages as a benefit. If the new service can provide 35 basis points or more, annually, of tax alpha it will break even or outperform the index. But that outperformance is still an open question, said Salaske. “I can just buy the ETF and avoid that risk altogether.”

Other risks, he said, are that a long-term market rise could mean not enough opportunities for tax-loss harvesting to generate high tax alpha, the possibility of having to receive and track hundreds of annual reports and proxy voting materials and coming up with a strategy for selling 1,000 stocks in a tax-prudent manner. He predicted that advisors would actually be called upon to help “clean up the mess” that direct indexing would leave behind.

As for the customization direct indexing will presumably provide? “Once you customize the index, it is just active management,” Salaske said. “Most investors are best served by using low-cost index funds.”

There’s plenty of potential in Schwab’s new offering, countered Ryan Caldwell, CEO of Wacker Wealth Partners, based in San Luis Obispo, Calif. The firm has $1.2 billion in assets, according to regulatory filings, and uses Schwab as a custodian.

“We generally get exposure to our desired asset allocation through funds, as opposed to individual stocks,” he said, but Caldwell is “interested in Schwab's active indexing capability.”

To be sure, Schwab isn’t the only firm with direct indexing portfolios.

Wealthfront—recently purchased by UBS for $1.4 billion—has had a direct indexing offering for years. That feature comes with a 25-basis-point fee and a $100,000 account minimum. The service allocates funds for up to 600 individual stocks with the largest market capitalizations in the U.S. equity market.

(For a $100,000 account, the average Wealthfront client will allocate about $30,000 to U.S. equities, according to materials provided by the firm. The “highest level” of the service is available once a client account crosses $1 million in assets. The median age for a client using direct indexing is 37.)

Morningstar partnered with TIFIN’s Magnifi to bring direct indexing to investors in August. That offering comes with no minimums and a 20- to 30-basis-point fee that is shared between the asset manager and TIFIN.

Other Schwab competitors are rushing forward with their own direct indexing plans.

Last year, Vanguard bought direct indexing platform Just Invest and Betterment laid a foundation for direct indexing with its remodeled custom portfolios. Later that year, BNY Mellon’s Pershing bought customized direct indexing provider Optimal Asset Management.

Schwab’s platform is “a home-built solution designed for scale,” said William Trout, director of the wealth management division at Javelin Strategy & Research.

“Schwab is sticking to its knitting in terms of targeting the affluent investor," he explained. The account minimum points to a targeted end client who is likely wealthy enough to have a financial advisor, "or at least savvy enough to appreciate the value of financial advice, even if in automated form," he said.

If Schwab were to provide the service to small clients with fewer assets, he said, it would prove an administrative and operational nightmare. 

Trout applauded Schwab's decision to limit its direct indexing to three indexes, which reduces complexity. In the future, he expects Schwab enhancements will make it easier for advisors to access the portfolios. The tool "fits neatly into the Schwab mantra of value for money."


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