Beyond ETFs: Direct Indexing

[This article appears in our September 2019 issue of ETF Report.]

You should assume I’m “an ETF guy.” After all, I head up a site called “ETF.com,” and our team publishes this magazine, which is called “ETF Report.”

I started my career in finance at the birth of ETFs more than 25 years ago, and I spend the vast majority of my time trying to help educate investors and advisors on how ETFs can help them make better investments.

So it came as a bit of a shock to some when my keynote at the 2019 Inside ETFs conference was about what comes next—after ETFs. And what comes next is “direct indexing.”

Beyond The Wrapper
One of the reasons ETFs have been so enormously popular—arguably the most successful financial innovation of all time—is they package several objectively great investment ideas in a single wrapper.

We know from decades of listening to Vanguard’s Jack Bogle (may he rest in peace) that controlling costs is incredibly valuable for long-term investors. ETFs, by design, disaggregate costs, leaving the vehicle itself with bare-bones investment management fees.

We know from basic math that, as a class, active investors must underperform the market because all investors are collectively the market before you consider fees. Put another way—every winning trade has a loser on the other end. And active managers are at a disadvantage right out of the gate because they’re generally more expensive than simply tracking an index. Unsurprisingly, ETFs have been predominately passive vehicles since inception.

We know from our annual dialog with the IRS that taxes can kill your long-term returns. ETFs have helped solve that problem. The ETF creation/redemption process allows investors to defer their capital gains bills until they sell their positions (and generate actual capital gains).

Evolution Always Coming
But just because ETFs have packaged these benefits doesn’t mean ETFs are somehow perfect. It’s easy to look at the world around us and assume this is the “end state” of human progress.

The Motorola flip phone in your pocket in 1999 seemingly couldn’t get any better, and yet today we literally carry supercomputing devices with us wherever we go.

For many investors, ETFs aren’t going to be an end-state any more than your old flip phone or a hybrid Prius is the end of innovation for phones and cars. So take heed: The future of investing is sneaking up on us very, very quickly.

Building A ‘Direct Indexing’ Portfolio
Thinking about what investors need to get from today to a wealthier tomorrow, it’s actually pretty simple:

• They need some sort of intellectual property—to know what to own to get from here to there.
• They need access to the securities that match that intellectual property.
• They need maintenance: buying and selling, reporting, managing tax issues, dealing with corporate actions, etc.

ETFs check the box for a lot of this. When you buy, say, the iShares Russell 3000 ETF (IWV), you’re getting all of this in one place. You’re relying on the intellectual property of FTSE/Russell for the list of securities worth owning. You’re relying on BlackRock to buy and manage that list of securities, following any changes Russell might make over time. And you’re counting on BlackRock to handle all of the rebalancing, distribution of dividends to you, managing the embedded gains of the portfolio, and so on.

That will cost you a single bundled fee of 0.20% a year. It’s a great deal.

How Custom Indexing Works
But direct indexing takes this a step further. Let’s assume you want to use the exact same intellectual property here as your core investment approach—you want to own the total U.S. market, and you’re leaning on FTSE/Russell to handle that.

In a direct indexing model, instead of finding the packaged product that maps to your needs, you go to a direct indexing provider such as Optimal Asset Management, Parametric, Smartleaf, Ethic or SMArtX to build your own portfolio. But instead of simply going and buying all 3,000 securities and charging you a similar fee, they actually ask you a few questions before they get started.

Is this taxable or tax-deferred money? Do you have any large security positions outside this allocation? Are there any companies you really don’t want to own? Are you passionate about any particular environmental, social or governance issues? Are you trying to own “the market,” or are you looking to get some sort of a tilt to your exposure (growth, value, momentum, etc.)?

Housed In Separately Managed Account
Based on these two inputs—your core intellectual property need, and your personal situation—they then build you a portfolio in a separately managed account.

This portfolio will likely be a bit different than IWM. Perhaps you’re an executive at Apple with a large incentive stock option plan and a slug of company stock. Well, you might end up with a “Russell 3000 minus AAPL” portfolio that’s actually much better for you.

And perhaps you really want to minimize your exposure to tobacco companies. Well, now you have a portfolio that is essentially the Russell 3000 minus AAPL and tobacco companies. And that portfolio can be further tweaked to minimize tracking error to the Russell 3000—perhaps increasing the weights of some other consumer stocks to make up for the missing tobacco companies.

Boring Part That’s Magic
The second half of a direct indexing relationship goes beyond just excluding and tweaking—it’s how you manage it over time.

In a normal ETF portfolio, the fund manager focuses extremely closely on managing to their index, especially around rebalances, index changes or corporate actions. Each one of those small changes can create a taxable gain, and so ETFs also rely on creation/redemption to “push out” low-basis shares as often as they can. For this reason, most ETFs have never paid a capital gains distribution.

But just because they’re distributing zero doesn’t mean they couldn’t do better.

No Tax-Aware Decision Timetable
In a direct indexing scenario, the portfolio manager can make tax-aware decisions throughout the year. If Wells Fargo has a terrible quarter and trades to a loss in the portfolio, it can sell that position and book that loss, replacing the exposure with other banks.

That tax loss can be used to offset taxable gains from other positions, or it can be used to offset $3,000 in ordinary income, or it can be used to offset gains from other unrelated transactions—the sale of company stock, for instance.

For many high net worth investors, that single-stock tax loss harvesting is a kind of magic that “cracks open” their portfolio, spreading across the entirety of their annual IRS filings.

Evolving Landscape
Many early leaders in this space have account minimums as high as $10 million. There’s some logic to those minimums, because with too small an account—say, $1 million or less—you can’t effectively manage the individual lots of securities. If the average stock price is around $60, then just owning one share of each stock in the Russell 3000 would be a $200,000 investment. And of course, trading single shares is rarely efficient.

Thankfully, there are ways around this. Many direct indexing firms now offer fractional shares. They do this by bundling all their trades across thousands of accounts together, and assuming some small level of risk in owning the “leftover” fractions of securities. That means you can, in fact, own exactly $124 worth of Berkshire Hathaway if that’s what the strategy requires.

What This Means For Advisors
Honestly, I think it’s the best development for the advisory market since the invention of the ETF. Dozens of direct indexing companies have platforms tailored to bring advisors along into this brave new world. This fundamentally enhances the client conversation through customization.

This isn’t a death knell for ETFs; far from it: It’s an evolution. ETFs will remain the vehicle of choice for millions of investors for decades to come. You’ll even see them as part of the allocations inside direct indexing accounts where they make sense (illiquid markets, alternative asset classes). But for your largest advisory clients? Now’s the time to be looking at the next big thing.