Direct Indexing To Kill ETFs? Not So Fast

You've probably heard the hyperbole over the past year: Direct indexing is "the ETF killer"; that by giving investors the ability to unwrap securities from the ETF wrapper, the ETF vehicle itself is doomed.

Not so fast, says Brian Langstraat.

The ETF isn't going anywhere, says Langstraat, whose asset management firm Parametric Portfolio Associates has over $170 billion of its $258 billion in assets under management tied to direct indexing accounts. Direct indexing, as versatile as it is, isn't a solution for all use cases—or all investors.

While at Inside ETFs 2020, we sat down with Parametric's CEO to pick his brain about when and why to use direct indexing, at what account size direct indexing makes sense, and how direct indexing could reshape ESG investment.

ETF.com: Direct indexing has been one of the hottest topics here at Inside ETFs 2020. Everyone wants to know: Will direct indexing replace ETFs? What do you think?

Langstraat: I don't think so. We’re certainly bullish on [direct indexing]. I think it's a huge product area, and I think it's going to be a trillion-dollar product one day, maybe multitrillion as the industry assets grow. But there are specific use cases for direct indexing.

It all comes back to customization. The only reason you're going to step away from an ETF—with its very low cost and ease of use—is if you value the customization, and you have a use case that supports that.

That's not everybody. It's not people with short time horizons; it's not people who are tax exempt and don't have other customization. Lots of money will remain.

But for investors who have those common use cases—those who want to focus on their after-tax returns; who are funding their account with preexisting securities; who have philanthropic or ESG goals—they are in a place to benefit from direct indexing.

However, doing that is more than just plugging a few inputs into a computer program and getting out a portfolio. The DIY market for direct indexing is probably very small.

If you really understand who would benefit from customization, and what it takes to deliver customization from beginning to end, we probably won't see account minimums much below $100,000. And we're going to see it embedded in an advisor situation, where the advisor can use direct indexing in combination with wealth management tools, estate planning, tax planning and gift planning.

ETF.com: You mentioned a minimum asset size where direct indexing makes sense. Will direct indexing then only be accessible to the largest investors?

Langstraat: Depends on how we talk about it. On the spectrum of investors—retail, mass-affluent, affluent, high net worth, ultra high net worth—it’s certainly not for everyone. In most cases, we offer our services at a $250,000 minimum, which is the core equity or core fixed income portfolio; that probably applies to a multimillion-dollar invested asset portfolio.

I think that [price] will come down. But if you can log on and buy a basket of ETFs for a few thousand dollars, then you should always do that.

ETF.com: The average age of the advisor just keeps getting older. Is somebody nearing the end of their career really going to embrace a new technology like this? And can the next generation of advisor, who has a smaller shop, embrace it too?

Langstraat: I don't think the age of the advisor is slowing it down now. I think we've hit critical mass. There's probably $300-400 billion in direct indexed wealth management products. Year over year, the compound growth rates are higher than they are anywhere else in the industry outside of ETFs. There's not a lot of growth in the asset management business.

The ETF is essentially a delivery vehicle for the asset management business. It has zero marginal costs and is super efficient for the investor and advisor.

Direct indexing doesn't have any of those characteristics. Each one of these [direct indexing] accounts has to be designed, implemented and serviced as a true separate account. Technology helps. But [with] an ETF, the frictions around buying and selling have been reduced to almost nothing.

Part of me says, because the ease of adoption is not there, you're not going to see that hockey-stick growth.

ETF.com: One of the biggest advisor trends is toward model portfolios. Outsourcing investment management offers convenience and ease, and allows them to focus on helping clients. Doesn't direct indexing just make things more complicated again?

Langstraat: One of the costs of direct indexing is complexity. It's also a limiting factor on its growth and adoption. That complexity leads to direct ownership at the client level of hundreds of securities. Those securities, depending on the environment you're in, have corporate actions, dividends, trade confirms, head statements.

Imagine I'm an advisor and I'm putting my clients in a basket of eight or nine ETFs, which is allocated by a third party. That’s a really efficient business model. Now I want to incorporate a direct indexing account. There's a hurdle now that the advisor must be convinced is worth the complexity to the practice. We try to find those right cases.

ETF.com: Let's talk about one of those use cases you mentioned: ESG. Could you elaborate on how this is an ideal use case for direct indexing?

Langstraat: We do a lot of ESG. It's the fastest-growing element of direct indexing for us. The assets that Parametric advises that have an ESG component to them went up 50% in 2019.

ETF.com: Wow. But were they starting from a small base?

Langstraat: From a multi-tens of billions of dollars base. We offer ESG investors the ability to create a viewpoint. We offer you screens, lots and lots of them, and you can say, "I don't want to own a company that has any of these characteristics"—fossil fuels or guns, etc. You can click those restrictions and we'll create a portfolio and remove those deviations for you. Or maybe you want to vote your proxies in a certain way. Or maybe you just want help in thinking about it.

We worked with a family office that’s very [concerned about] human trafficking, and how to build a portfolio that expressed their values around human trafficking. So, we created a custom screen. They were very excited about that, and we took it to our other clients, and they were excited about it, too.

ETF.com: Nobody wants to invest in slavery.

Langstraat: Yes. Another example: We spoke to an advisor who had a client who's concerned about the death of the local mom-and-pop retailer, and the effect of Walmart (WMT) and Starbucks (SBUX). What does that mean? How do you reflect that? Do you want to exclude those stocks, or something else?

That's the kinds of conversations we have. The advisor of the future needs to be able to talk through it with their client, then show them a portfolio of next quarter, and the next quarter and so on, to show how it's different.

ETF.com: Is ESG the biggest growth driver of your business, then?

Langstraat: Actually, taxes are by far the biggest, because the demonstrable benefit is so enormous relative to anything else.

It varies by client. But if you compare us against the straw man of an ETF investment, over 10 years, if you put the same initial cost-basis cash into an ETF versus a direct indexing Parametric account, you're looking at 100 to 150 basis points of additional performance in the customized account versus an ETF, on an after-tax basis.

ETF.com: Interesting, considering how tax efficient ETFs are compared to mutual funds. The concept of tax efficiency can still be iterated upon.

Langstraat: There are very few consistent sources of excess return you can count on. Relative to an ETF, you'll pay about 25-30 basis points more of all-in cost, but you can reap 150 basis points after tax. And you can build it around your preexisting securities; you can implement your ESG and philanthropic goals.

This becomes one of the best trade-offs I believe in asset management. It's not going out and picking good stocks, or timing the market, but the value relative to the fee and the risk.

Contact Lara Crigger at [email protected]