What You Need to Know
- There is new hope for active managers who have been losing market share to the passive side of the business.
- Direct indexing enables firms to customize portfolios by holding the underlying securities to mimic a separate account structure to track an index.
- With these new powerful tools, advisors literally can do the portfolio rebalancing that once took days in just minutes.
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.”
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.