Journal of Financial Planning: March 2022
Bridger Cummings is assistant editor of the Journal of Financial Planning. He can be reached HERE.
Danielle Andrus is editor of the Journal of Financial Planning. She can be reached HERE.
JOIN THE DISCUSSION: Discuss this article with fellow FPA Members through FPA's Knowledge Circles.
FEEDBACK: If you have any questions or comments on this article, please contact the editor HERE.
I’d like a veggie burger—hold the onions, with a side of sweet potato fries. Isn’t it nice to get exactly what one wants? People love to express themselves, and they like customization. Smart companies have been capitalizing on that for some time now, and they are the ones that are capturing the market of people who want something more individual than just what can be grabbed off the shelf.
Bespoke Investment Solutions
I like to think of a good stock index like a good burger; a whole product comprising many different ingredients that come together beautifully. Someone else has already identified the main ingredients, the toppings, the sauces, the spices to give that burger its certain je ne sais quoi.
Likewise, a stock index has already identified some of the best candidates for what that index is meant to track. But what about investors who want most of what that index tracks, but not all of it? As in so many areas of our lives, technology has an answer to that question.
“The whole secular trend that’s occurring around personalization at scale in fintech, and financial planning broadly, really opened itself up to the ability to use technology to more effectively construct personalized outcomes,” according to Adam Green, CEO and co-founder of YieldX, a direct indexing platform that focuses on fixed income. “We’re seeing this across all different aspects of people’s lives where technology is helping them achieve more directly relevant results.”
Tech-powered direct indexing gives advisers the capability to offer these personalized portfolios more efficiently, effectively, and at scale, Green said. While the capability and subsequent adoption of these platforms are relatively recent trends, he believes they have staying power as advisers become more comfortable with using technology.
As the list of big-name firms buying up direct indexing platforms gets longer, it’s clear that industry leaders are betting on broader interest in direct indexing.
“That whole trend is facilitating much better-quality solutions than have ever been possible before. So, the tailwinds are definitely there, and it’s happening very quickly,” Green said.
He noted the influence that aging millennials have in driving the appetite for tech-based investment solutions.
“You have a whole generation of more mass affluent people emerging into their prime earning years and really thinking about ‘how does my future look relative to what it may have meant, and what the goals and objectives have been, for previous generations?’” he said.
Who’s Buying into Direct Indexing
Direct indexing is something that has historically only been available to relatively wealthy clients since it had higher trading costs. Since all (or most) of the underlying stocks need to be individually purchased, it caused a lot of overhead for investors who wanted to skip the fund and go straight to the source in their own brokerage account. But with modern methods of digitally trading and record-low trading costs, in addition to more brokers allowing fractional trading, this door has been opened to pretty much every investor out there.
Direct indexing “spans the whole net-worth spectrum,” according to Green, “especially over the past few years with this retail investment revolution with the fractionalization of assets. We’ll see more and more of that with digital assets and blockchain becoming more mature over time.”
He added that direct indexing is especially relevant to fixed income investors. “Fixed income indices are constructed by how much debt each issuer has. The end user can figure out, are they debt-cap weighted, are they market-cap weighted? That’s suboptimal from a return perspective, so why own companies with a lot of debt? Direct indexing allows you to optimize away from that,” he said.
ETFs or mutual funds still tend to be cheaper than direct indexing, especially if the funds are passively traded. It’s about three basis points for ETFs as of September 2021, and it’s about 20 to 40 for direct indexing, but that’s still not bad, and it’s a cost that investors who want to stick to their values can stomach (Gurdus 2021).
Michael McKevitt, CFP®, director of financial planning at Guillaume & Freckman, Inc., said his firm is managing 12 direct indexing accounts.
“By running it ourselves, we don’t have minimums we need to hit to get on another platform, so we really can focus on clients who it makes sense for. Right now, that is business owners and large clients who want the tax-loss strategy to offset large capital gains they currently have or that will be coming from the sale of a business.”
As for investor appetite for direct indexing, Patrick O’Shaughnessy, CEO of O’Shaughnessy Asset Management, has seen significant demand from clients who have access to these platforms. His firm launched Canvas, a custom indexing platform, in 2019.
“When we give people these tools in a custom index platform or a direct index platform, about 80 percent of them completely customize their strategy. So, I think this is where the world is going. Technology allows this to happen,” he said in an interview with CNBC.
O’Shaughnessy Asset Management is among the firms snapped up by larger asset managers in 2021; in this case, by Franklin Templeton, which paid an undisclosed amount for OSAM and Canvas.
Benefits of Direct Indexing
The benefits that investors are buying with direct indexing include reducing unwanted exposures, tax-loss harvesting, and the potential for ESG portfolios that are more finely tuned to their personal values.
In the past, most people invested with the sole goal of getting strong returns, and it could be difficult for those who didn’t want to invest in “sin stocks.” By direct indexing, investors who like most of an index but want to avoid some holdings that are contrary to their values can simply not get those stocks. An index provides a solid foundation, and investors can individually screen their custom index for stocks they don’t want to be involved with.
“Off-the-shelf indices don’t allow that, so you’ve no idea really what the parameters are from an ESG perspective for off-the-shelf products,” YieldX’s Green said.
Another benefit of direct indexing is for people who work in an industry or a company that is present in an index. If somebody works for Amazon or Apple or in a heavily represented industry like healthcare or insurance, they might have too much risk in their portfolio if they simply buy an ETF. For example, an Amazon employee with stock options might choose to direct index the S&P 500 while removing Amazon, so they are not overly exposed to the risk that one company can have on their portfolio. It’s slightly counterintuitive to purposely not bet on your own company, but it does make sense for the rational investor.
Kenneth Nuttall, CFP®, chief investment officer at BlackDiamond Wealth Management, appreciates that feature of direct indexing.
“We use direct indexing a good bit. We like it for clients who have concentrated positions or work for a company, and we remove that company and similar companies from their portfolio,” he said. “We also love it for the tax harvesting capabilities. It helped a lot in 2020 as there were a lot of opportunities. Our clients stayed right on top of the index while also getting tax losses. Tax losses were used in other parts of the portfolio to sell appreciated assets.”
Screening an index, even one as big as the S&P 500, doesn’t mean that advisers and their clients have to sort through and select the 450 stocks that remain. Modern software can be used to find stock correlations, and some experts say it’s only necessary to have about 75–100 of the stocks in the S&P 500 to closely match its returns (Templin 2021).
Direct indexing also allows planners and their clients to diversify their exposures across multiple accounts, Green pointed out.
“If you think about these wrapped products and fund products, you don’t know the constituent level holdings that you have, so if you’re invested in a number of ETFs and mutual funds, you could actually have a lot more concentration than you think. The ability to use direct indexing can help solve for that. Then you can combine strategies where you have hybrid indices that are customized rather than off the shelf,” he explained.
An additional benefit of getting the stocks directly is that you can vote in shareholder meetings, whereas with an ETF you can typically only look in from the outside. BlackRock announced in October 2021 that it would open the door for institutional investors to vote at shareholder meetings as of January 1, 2022.
More on Tax-loss Harvesting
If you buy an ETF, you are stuck with the whole basket, both over and underperformers. A great advantage of direct indexing is that investors can sell stocks that are not doing well and replace them with similar stocks in the index that are doing better. Software that identifies options that are similar—but not too similar—can help investors avoid running afoul of the IRS’s wash-sale rule.
But that’s only the tip of the iceberg. By selling losing stocks, you can also claim those capital losses in the form of tax-loss harvesting. You can’t do that when buying a fund unless the entire fund performs poorly. These capital losses can be used to offset your regular income taxes and can also be used in future tax filings to offset your future capital gains taxes (Baldridge and Schmidt 2021).
Inspiring Enthusiastic Clients
Word-of-mouth marketing is one of the strongest forms of marketing. Restaurants love it when people post photos of their juicy burgers on Instagram, especially if the Instagram user tags the location. Custom clothing often gets inquiries as to where the person wearing it got it, as people want something that speaks to them.
A custom portfolio isn’t quite as glamorous, but you never know what your clients are going to be talking about during their cocktail parties. If they end up talking about their investing plans and how you were able to help them invest in exactly what they wanted, your name might just be dropped.
A Double-edged Sword
Direct indexing isn’t all peaches and cream. There are some downsides. Chief among them is that it isn’t as cheap as just buying an ETF. On the other hand, the fact that one can tax-loss harvest might make up for it. Research by Chaudhuri, Burnam, and Lo (2019) found that tax-loss harvesting resulted in alpha of 1.10 percent per year, falling to 0.85 percent when limited by the wash-sale rule.
Another common criticism of direct indexing is that, over time, clients might eventually sell off all the underperforming stock, which will mean they won’t have any more possibilities for tax-loss harvesting.
A final criticism sometimes cited is that you might miss the next up-and-coming stock that isn’t in the index yet, or that you just haven’t added in yet (Templin 2021). That is true, and it just goes to show that even with a well-defined index, you still should keep your ears on the ground for any new developments. By utilizing direct indexing in a separately managed account, away from their other portfolios, clients can keep their passive investments and have an opportunity to jump on the latest trend before all the profit has already been squeezed out of it.
The Future Is in Individualization
Henry Ford famously said, “Any customer can have a car painted any color that he wants, so long as it is black.” That mindset works well at the onset of a venture. When you need to ramp up production, it’s best to have a one-size-fits-all approach, so you can create efficient assembly lines or lower client costs and stay in business. But after a while, people are going to want their custom products, and investors are hungry for that now.
Ford, Nissan, Tesla, and pretty much every car manufacturer is now offering customization. Many other industries are moving in this direction, too. Some firms might stand by the sanctity of how they have created their product offerings, but customers who do want customization might not return.
It’s still a good idea to offer simple, affordable solutions, but don’t exclude the potential clients who are going to look elsewhere if you refuse to cater to them. By creating or implementing platforms that allow your clients to create the direct index that truly represents what they stand for and that will deeply benefit them, you will find yourself positioned to bring in those clients with specific investing goals. They will feel heard, and they will likely be a more loyal client when they feel that their values are being recognized in their investment choices.
References
Baldridge, Rebecca, and John Schmidt. 2021, March 25. “Can Tax Loss Harvesting Improve Your Investing Returns?” Forbes Advisor. www.forbes.com/advisor/investing/tax-loss-harvesting/.
Chaudhuri, Shomesh, Terence C. Burnham, and Andrew W. Lo. 2019, March 5. “An Empirical Evaluation of Tax-Loss Harvesting Alpha.” Available at SSRN: https://ssrn.com/abstract=3351382 or http://dx.doi.org/10.2139/ssrn.3351382.
Gurdus, Lizzy. 2021, September 16. “Direct indexing Is Like Customizing a Tesla, but with Your Portfolio, Investor Says.” CNBC. www.cnbc.com/2021/09/16/direct-indexing-is-like-customizing-a-tesla-investor-says.html.
Templin, Neal. 2021, December 2. “The Pros and Cons of ‘Direct Indexing.’” The Wall Street Journal. www.wsj.com/articles/pros-and-cons-of-direct-indexing-11638390453.
