Evan Harp: What are the big takeaways from this study, and what do you hope advisors will walk away from it thinking about?
Tom O’Shea: The big takeaway is that there’s very little awareness of direct indexing among advisors. Only 14% of advisors have heard of it, and yet there’s a real benefit to it. Particularly those advisors we think manage anywhere from $500,000 to maybe $3-5 million per client. In other words, that’s their target market – that size of a client, probably around 2 million.
We talked to a lot of those advisors last year and very few know about direct indexing, and our research data also shows that they’re very unaware, but if you ask them about it, they want you to define it for them. Well, we told them it’s a product that allows you to get exposure, say to the S&P 500 – passive investing – but at the same time generates an extra 100 to 200 basis points after tax return. Does that sound interesting to you? They all said yes! How can I find out more about it?
So the reason we wrote this white paper is to educate advisors about direct indexing. Last year we wrote a white paper about the size of the market and its growth, but this is a white paper that has several examples of how advisors use direct indexing because there’s essentially this void of awareness and education. A lot of firms are starting to fill that gap. Because a lot of big firms that are huge marketing machines – whether it’s Morgan Stanley buying Eaton Vance to get access to Parametric, Blackrock buying Aperio, or Franklin Templeton buying Canvas, or so many other examples of many acquisitions, that now you have a lot of marketing behind it. Whereas, in the past, you didn’t. There were only really, maybe two or three players in the space.
Evan Harp: Clearly there are a lot of advantages to direct indexing, and a lot of the people talk about the tax benefits, particularly its ability as a tax loss harvest vehicle. I’m curious how it helps retirement accounts, which don’t usually have that as a factor.
Tom O’Shea: It is not going to generate a tax benefit for someone who holds assets in, say, an IRA. But what many people believe, and we certainly believe, is that, over time, it’s going to be used for ESG. You can also do tilting, like factor tilts, such as low vol. You can change exposures to risk, but if you talk to most of the firms in this space that we do, they really think that as the younger generation becomes more invested in the stock market, building their own portfolios, that they’re going to be interested in ESG. We don’t see it among older investors as much.
For example, if you ask people under the age of 40, do they agree with a statement that says “I want my investments to align with my values?” Then you get a significant amount, 70-75% of them will say “yes.” That number almost drops in half when you get to people over the age of 60. They just aren’t as interested in it.
What we found, though, is some advisors who are worried about generational wealth transfer, are brushing up on ESG. So, when these clients inherit their parents’ money, they’re going to be able to respond to it.
This product is very popular in family offices, multi-family offices, and advisors that cater to very wealthy families. You see a lot of younger people that are interested in leveraging ESG. That’s sort of where I think you would see it in the IRAs.
Evan Harp: That ESG point is an interesting one to me. It’s been something of a controversial issue this year, with a small, but vocal, cadre of anti-ESG issuers and investors making a lot of noise. Then there are people who broadly agree with the principles of using an ESG lens, but have trouble with just how general and slippery ESG definitions can be. Can you go over some specific ways that direct indexing can help investors adhere to their values?
Tom O’Shea: Well, let me just say to that point, before I come up with some examples, yes. When we interviewed advisors on ESG, I’d say about 10-15% got angry. I mean, they got mad! They said they didn’t want to talk about it. It’s all “woke” politics.
What I think they’re reacting to is this sort of politicization of ESG. In another name, it was called “socially responsible investing.” I think the “E” part really gets a lot of climate deniers worked up. In an SMA, here’s the thing – it’s not about you and your values as an advisor. It’s about your customers’ values. They might have values that diverge from yours, but direct indexing lets you be idiosyncratic in how you uniquely encapsulate the client’s values. Isn’t that something that you should be doing? Doesn’t that help you, as an advisor, get closer to the client and develop a deeper relationship?
So yeah, it is politicized. The fact is you can, instead of say, invest in an environmental fund, you can invest in specific environmental causes by looking at different securities… You can get much more granular.
Now, what are some examples? Well, we ran into an example of a wealthy person that wanted to just focus on human trafficking. They were able to work with their asset management partner and do that.
You bring up a good point that, unlike in Europe, ESG is not as well defined here in the United States, which makes it difficult to implement. Certain people can come in, and you can see this in a lot of the technology that gets built. Let’s take two examples where this it’s not really all left-wing “woke politics,” right? A politically-conservative person might tell their advisor: “I don’t want to invest in companies that produce certain drugs.” Well, guess what? That’s ESG. Another politically-liberal person might say: “I don’t want to invest in companies that pollute.” With direct indexing, ESG isn’t about one particular ideology – it’s about your clients’ personal beliefs
People are not political binaries, we think that you might find somebody who actually embraces both of those values, right? You can get as unique as possible by working on these technology front ends as an advisor, with a client, to make sure that certain things are avoided that a particular client doesn’t like.
I’m surprised by the whole ESG thing and how it’s playing out, but a lot of that is institutional as well, Evan, it’s more like governors talking about their state pension plans, which I get that everybody’s got to ride the bus on the pension plan. That’s different, but that’s not what we’re talking about here. We’re talking about individual, personalized accounts.
Evan Harp: You touched on this generational split that is emerging in terms of how people want to invest with their values. You also mentioned in the paper, there’s a lot about what direct indexing can mean for downmarket investors, and I’d love to hear you speak to what it can mean to the democratization of investment in general, beyond just younger people inheriting their wealthy parents’ fortunes. What does direct indexing mean for people who don’t come from wealth? How can direct indexing be a useful tool for those kinds of investors that maybe other investment vehicles aren’t?
Tom O’Shea: Yeah, so you have firms like , which is offering an SMA for $2,000, and Fidelity, which is offering one for $5,000.
Essentially, what you do is you sit down with them and say “I’m interested in avoiding these particular industries,” and they’ll help you flag those industries as not to be invested in and then they’ll build, through an algorithmic process, a portfolio that avoids those industries.
It’s usually a couple of factors that you can use in a small account, you can’t use too many because the trade-off here is the tracking error to the index. Now, interestingly, we’ve spoken to some advisors that say it doesn’t seem like their clients care about the tracking error so long as they don’t invest in these 10 things. As long as that’s explained to the client, the tracking might be large and many clients are okay with that. Generally speaking, when you’re talking about advisors catering to lower balance clients, you’re going to see a lot more of “here are the 10 dials you can use, and you really should focus on a couple of them, and then we’ll press that button and that portfolio will be constructed and traded.” A lot of automation has to happen upfront for these smaller accounts to be profitable.
Evan Harp: That makes a lot of sense. Because direct indexing is so customizable and seems to have a lot of capacity in that way, how do various direct index providers differentiate and set themselves apart from one another?
Tom O’Shea: That’s a good question. There are ways in which algorithms can be a little different from one another, but they don’t seem to focus on that.
I think, at this point, where they’re going to differentiate, I believe, is in brand and service and ability to develop relationships with clients. I’m thinking of particularly those that sell through distribution networks, as opposed to directly to the consumer.
What’s happening is in those firms that are already successful, say Parametric and Aperio, they do their best to service like crazy these accounts. I think that’s going to be a point of differentiation. You bring up a really good point, you’re essentially giving people exposure to the S&P 500 and I guess the thing that’s going to differentiate you is technology to help you do that, to not only help you construct the portfolio, but measure how it’s tracking against the index, and also how it’s tracking against your values. Then, tax savings. So there’s a lot of technology, and the simpler that is, the ones that have the most simple interfaces, they’re going to be the ones that really are the most successful.
With all things, there’s the complexity of what you’re offering underneath and the simplicity of the user interface. Trying to find that balance is going to be important.
But you bring up a good point, nobody’s saying “I can beat 80% of my Lipper peers,” right? That’s not what this is about. These firms are going to have to compete on things outside of the normal investment thesis.
Evan Harp: How do you see direct indexing growing compared to, say, ETFs?
Tom O’Shea: It’s going to be different because direct indexing has been around since the 1990s. It’s not a new product. You have Parametric launching their product in the 90s, and then Aperio, in the 2000s. The reason there’s a novelty to it now is because of fractional shares and zero commission trading, which allows a portfolio manager to construct a direct index SMA at a lower account minimum and not have tax benefits get eaten up by a lot of trading costs.
Let me just say, as an aside, direct indexing is not going to replace ETFs. I’m so sick and tired of hearing people ask me, “when is this going to surpass ETFs?” I’m going to be retired if it ever does happen.
It’s not the $2,000 or $5,000 accounts that are going to make direct indexing grow in the next three to five years. It’s that group of advisors that we spoke to, who have a multi-million-dollar client who could benefit from this because they have a high income. In other words, those advisors with affluent clientele who are just now learning about direct indexing.
We know about the marketing that’s going to go into that, we see all these big firms who’ve made huge investments, either acquisitions or outright investments in their own technology to get into this market. They’re going to push these products to realize a return on that investment. So between the lack of awareness, the obvious benefit, and the new marketing you’re going to see coming forward, that’s where the growth is going to come – a new wave of growth if you will.
Traditionally, this product had been in the province of family offices, multifamily offices, and ultra-high net worth investors, because the account minimums were just so high. Remember one account was really just one component, one asset class of a client’s total portfolio. So say if it was a $500,000 minimum account, and that was your large cap equity exposure, you need to populate it with other investments in other asset classes. So you really were talking about wealthy people.
The product lifecycle is going to look like it has two humps. Over the past decades, direct indexing was very successful in capturing a lot of assets in the family office, multifamily office, and ultra-high net worth advisor community, but now it’s going to grow as it broadens out to lower wealth tiers and over time as awareness grows amongst consumers because the big direct-to-consumer firms are staring to market direct index solutions
Evan Harp: What’s one thing that people get wrong about direct indexing?
Tom O’Shea: I think they feel it’s too complicated.
That’s really the fact that you often hold a lot of positions in order to mimic the index, and that complexity is something that scares off a lot of advisors. At its heart, it’s not really all that complex because it’s an algorithm that you are giving constraints to and then running.
Now, yeah, the math, if you don’t know linear optimization, that can be daunting to describe what an algorithm is. You don’t need to know linear optimization, right? It’s like, do I need to know how the internal combustion engine works for me to drive my car? Do I have to be able to take that apart and put it back together? No!
Over time, driving a car has gone from cranking it up and using a clutch to having to press a button. Now, I don’t even have to do that. My key, when I get near my car, tells it to open. So what’s happened is a lot of technology is being layered on top of this to make the construction and the reporting of the portfolios easier. I think that’s when advisors start to see that, it will really help them embrace direct indexing.
One more thing: We’re excited about direct indexing, but right now, it’s roughly a $400 billion market, right? We say that it is going to grow to $825 billion in five years.
As I mentioned earlier, a lot of people then ask, “When is direct indexing going to totally surpass the ETF?” Well, the ETF market in the United States is a $7.1 trillion market today, and it’s going to be an $11.3 trillion market, we project, in the next five years.
What people get wrong – and this is because, I think a lot of the hyping, particularly of ETFs has been “they’re category killers,” this is a Silicon Valley mentality. It’s not good for us in the financial services industry. What’s happening is sometimes a direct index separate account makes more sense for the client. Sometimes an ETF does and sometimes a mutual fund does. What’s happening is all these wrappers are going to coexist going forward, and advisors need to discover how they can combine these products to give the client the best portfolio possible.
