How Direct Indexing Can Save the Investment Management Industry

Most of the recent developments in the investment management space have been pretty terrible for asset managers and advisors focused on providing investment services.

Fees are going to zero, low-cost digital competitors are gaining popularity, operating expenses are being questioned from investors and regulators alike, and growing behemoths such as Vanguard and BlackRock are vacuuming up almost all of the asset flows, leaving the rest of the industry in disarray.

At the same time, the value proposition for financial advisors is rapidly shifting from providing investment services to becoming more planning-centric, further pushing asset management to the back seat in their service offerings.

In addition, the majority of investment managers don't beat their benchmarks. As a result, the indexers are winning — so much so that in the $11.6 trillion equity fund market, active management is continuing its losing streak to passive investing, according to Bloomberg. Currently, passive commands a 54% market share, having taken the lead over active in 2018, with no signs of giving it back anytime soon.

Many in the industry argue that these secular trends are the final steps in the complete commoditization of investing and that asset managers and advisors should heed the words of the Borg from "Star Trek": "Resistance is futile."

New Hope

Amid these dark days in investment management, however, there is new hope: direct indexing. Although this interesting approach to personalizing portfolios has been around for some time, it has typically been limited to large portfolios due to the time and cost involved. But with dramatic innovations in trading and rebalancing technology and fractional share availability, combined with no more trading costs in the form of commissions, direct indexing has become affordable and applicable to portfolios of all sizes.

Direct indexing enables firms to customize portfolios by holding the underlying securities to mimic a separate account structure to track an index. Or it will adhere to a model portfolio to accommodate constraints and opportunities in that portfolio, such as tax-loss harvesting, concentrated positions, and environmental, social and governance mandates — which in and of themselves are revolutionizing investor demands.

Previously, SMAs and wrap-like accounts have been the solution for advisors working with their high-net-worth clients to accomplish these objectives. But those SMA programs have traditionally had high costs and complexity that prevented advisors from using them with all of their clients.

The good news for the industry is that new trading and rebalancing technology makes it possible to replicate the SMA process to create model portfolios or manage to an index by holding the individual securities and fractional shares themselves that make up the index or model portfolio. This replaces having to use less precise and more costly methods, such as investing in a mutual fund or ETF.

This technology makes it possible to efficiently deploy tax-loss harvesting, accommodate a large legacy position or manage to an ESG mandate without changing the risk profile of the portfolio. For example, portfolio managers can pretty much replicate the risk/return profile of the S&P 500 index with roughly 30 to 40 different stocks rather than holding all 500 of them.

From there, powerful rebalancing and trading technology using innovative algorithms can provide alerts to tax-loss harvesting opportunities, or place constraints for ESG reasons on buying stocks of companies that are part of an index or model portfolio, as well as for concentrated position management to minimize capital gains taxes on holdings that have a low cost basis.

For the tax-loss harvesting opportunities alone, portfolio managers can deliver a significant "tax alpha" that can more than make up their additional fees for actively managing the portfolio. As a result, direct indexing can justify premium pricing and be a healthy start to un-commoditizing investing, making it the best thing to happen to the investment management space since the 12b-1 fee was gift-wrapped for the industry by sympathetic regulators back in 1980.

Combined with the near fever-pitch demand from clients for ESG investments, direct indexing will be the new black for easily creating ESG portfolios, providing advisors and asset managers with a compelling marketing message to justify premium pricing, and returning much-needed profitability to this embattled sector.

Big Player Action

Thus, it should come as no surprise that the direct indexing movement has not been lost on the industry's largest players. Vanguard, in the very first acquisition in the firm's 46-year history, recently picked up the direct indexing innovator Just Invest.

"Technology-driven solutions such as direct indexing continue to reshape our industry, driving better investment outcomes and lowering costs for clients," said Tim Buckley, Vanguard chairman and CEO, in a statement announcing the deal. "Wise investments in technology are an important equalizer, enabling us to democratize valuable investment capabilities and products."

History has shown that whenever Vanguard democratizes anything, it has a ripple effect on the rest of the industry. This means direct indexing is likely here to stay.

Other major deals in the asset management space have seen similar large firms acquiring this new technology, including J.P. Morgan with its acquisition of OpenInvest, BlackRock buying Aperio, and Fidelity inking an equity partnership with Ethic. Of course, all of this started with Morgan Stanley's purchase of Eaton Vance last year; Eaton Vance had the foresight to acquire The direct indexing pioneer Parametric back in 2003. Look for any boutique asset manager with the words "direct" and "indexing" on their website to be next up for acquisition.

On the technology front, Orion has been ahead of the curve with the launch of its innovative rebalancing and trading application, ASTRO, integrated into its Eclipse trading platform a few years ago. ASTRO is one of the first technology tools available directly to advisors to get them into the direct indexing game, along with Advent's Black Diamond rebalancer. Look for other tech platforms to enhance their direct indexing capabilities at lightning speed to avoid getting left behind.

Asset managers and advisors with these new powerful tools can literally do the portfolio rebalancing that once took days in just minutes, dramatically increasing the benefits they can deliver to clients. In a sea of sameness, firms that can deliver a direct indexing approach now have the chance to feel good about themselves, while justifying higher basis points for value delivered.

Many have predicted that technology innovation would be the death knell of the investment management industry — and they have pretty much been correct these past decades. In this case, however, technological innovation in direct indexing capabilities has the potential to stave off that extinction, at least until the next innovation comes along. Until then, asset managers and advisors providing investment management services now have a new message to once again differentiate themselves as truly value-added providers.

Timothy D. Welsh, CFP, is president, CEO and founder of Nexus Strategy LLC, a consulting firm to the wealth management industry. He can be reached at [email protected] or on Twitter @NexusStrategy.