The Next Generation of Indexing Strategy: Direct and Custom Indexing

Index investing has steadily gained popularity and evolved exponentially with technology since the first public indexing strategy was launched in 1976. Index strategies are exactly what they sound like: they are mutual funds or ETFs (essentially mutual funds that trade daily on an exchange) that seek to track the performance of an index, whether that is the Dow Jones Industrial Average (US), FTSE 100 (UK), or the Nikkei 225 (Japan). At its core, index investing offers an answer to a fundamental question: Why pay more money for an active fund that tends to underperform the index it is supposed to beat? Assets Under Management (AUM) in indexing strategies (mutual funds and ETFs) surpassed $10trillion in 2020, and ETFs alone are projected to reach $50trillion AUM by 2030. As technology grew more sophisticated, so did Indexing, by putting tracking rules in place to isolate certain portions of an index based on investor preference (often called Smart Beta). Rather than investing in the entire broad US stock market index, it is possible to invest in US stocks exhibiting upward price momentum, dividend growth, lower downside capture, or high ESG scores. With the advent of purchasing fractional shares, investing has become a realistic option for everyone, unlocking an estimated $173billion from the roughly 71% of Americans alone who are considered financially underserved. Now, in 2021, the indexing industry is once again on a new frontier of its latest evolution: Direct and Custom Indexing. 

For the purposes of this article, Sia Partners defines Direct and Custom Indexing as follows:

• Direct Indexing is an investment approach that aims to replicate the performance of an index by purchasing individual securities in the index as opposed to through a mutual fund or ETF wrapper. Ownership of individual securities provides investors with more control over their portfolios and allows for certain tax strategies not available through packaged products.

• The Custom Indexing approach takes diversification a step further and allows investors to customize a portfolio based on personal preferences and investment goals. Investors can create a diversified portfolio that is tailored specifically to their investment objectives by choosing securities to be excluded or swapped from an index.

The exploding popularity of investment platforms like Betterment, Wealthfront, Robinhood, Stash, and Acorns should come as no surprise as Millennials and Gen Z investors are looking for investment platforms with streamlined and intuitive UI/UX that serve their investment and retirement needs with hyper-personalized options. Those needs take various forms: a user above a certain income level may want to explore tax strategies, a company executive likely needs to diversify their portfolio from their corporate stock plan, more savvy clients would ask for more detailed performance reporting and some investors might want to put their money where their values align. Plus, the impending largest generational wealth transfer ever from Baby Boomers to Millennials could set as much as $70trillion into the hands of the Millennial demographic. In the current competitive landscape, as a wealth manager, asking a client to fill out a stack of paperwork with financial background information only to offer a portfolio of ETFs is likely not enough to retain a new generation of clients or attract new ones and their assets. If there was any doubt that there is new competition for assets, in February 2021, an industry leader in Direct and Custom Indexing reported surpassing $1billion in AUM in its first year of 2020, with 58% coming from new clients.

• Direct and custom indexing puts customers in control of their own investment solutions. Investors can create unique investment indexes or alter existing investment indexes to their preference. Investors can tailor the risk/return profile, geography, industry, ESG preference, or any other factors. 

• Being able to build off the success of other portfolios is a powerful and useful tool for all investors.  Investors who feel strongly about a sector and want to add more exposure to a diversified index, or for an investor who would like to remove any conflict investments from an index, such as tobacco, gambling, etc. Research has found that adding an ESG lens to a portfolio can not only reduce risk but also generate excess returns. For example, an employee of a Fortune 500 company who wants to invest in the S&P 500 but already has stock or stock options in his or her company would benefit from custom indexing.

• Custom indexing is useful because it builds client involvement and trust. Since wealth management relies upon strong relationships and a personal approach, a custom indexing exercise is another step that meets client evolving objectives. 

• A key benefit of direct and custom indexing is for tax harvesting purposes. For example, if an investor-owned a basket of individual stocks versus a consolidated index of those stocks, the investor could sell off losing individual stocks to realize a capital loss or realize gains on winning individual stocks if the stock were to go extremely high, for example. With an index, an investor is forced to buy or sell shares in the index, meaning that tax-loss harvesting or gain realization on specific stocks is not possible. 

• Adding a direct or custom indexing offering could facilitate customer acquisition and help a firm to attract customers away from other firms that do not offer such a strategy. 

• Direct and custom indexing can be a profitable solution for wealth managers. Wealth managers may be able to charge extra fees to clients for creating custom portfolios versus just buying an index, meaning that the wealth manager would be able to earn extra fees on top of their regular fee structure. Additionally, wealth managers could collect additional revenue by collecting the entirety of the management fees from the client, as opposed to only collecting a partial amount and having to pay a percentage of the take to the asset managers that manage the packaged index products.

• Direct and custom indexing solutions will require Wealth Management firms to develop new tools or to modify their existing investment management systems. This process will not only be time-consuming, require extra human capital, but also cost money. Wealth managers firms must also make sure this process does not interfere with the existing client experience. 

• A custom indexing solution will require the creation of a set of filters to recognize conflict investments and ESG scores on portfolios. 

• Direct indexing can create rebalancing issues for wealth managers, as the prices of individual stocks change in value. If individual stocks get too far out of the target allocation in value, wealth managers may be forced to buy or sell shares in existing holdings. This can be inefficient from a tax standpoint, time-consuming, and require excess cash.

• Direct indexed portfolios have a more complex reporting process than ETFs. This is because there are many more positions involved, and because there may have been trading in the account for rebalancing, adding new positions, cutting positions, or for tax-loss harvesting. This can create additional responsibilities for firms and clients. 

• Direct indexing can create price risk and tracking error for investors as the result of buying many securities versus one ETF. In the process of buying many securities over a period, investors may be faced with higher or lower asset prices than if done at once, as the market prices of securities change.

• While customization has its benefits, over customization can increase portfolio risk and endanger client suitability. Fund managers should consider the limits of over customization and make sure that customized indexes are within the limits of client risk tolerances and return requirements.

As direct and customer indexing moves mainstream, it is important that Wealth Managers, Institutions and Advisors, recognize the possibilities behind it and capitalize on individuals looking to invest in this way. 

Larger Wealth Management firms have recognized the growing trend behind custom and direct indexing and have found ways to integrate these offerings into their businesses. This has been achieved through either investing in the technologies behind building out their own platform or acquiring companies with superior capabilities and bringing them in-house, and there has been high-profile market activity recently surrounding the latter. 

A large broker-dealer with a pre-existing, robust SMA platform, using fractional shares, could offer more scalable SMA or investment solutions. While these firms already offer customization to their SMA clients, they could capture more AUM by offering the white glove customization service for their retail clients who do not hit their annual minimums or cannot afford to purchase whole shares of certain stocks. 

Another option for large Wealth Management firms to offer custom and direct indexing is through merger and acquisition. As seen through recent mergers and acquisitions in this space. By providing these services through SMAs, the result is active management that has the advantages more typically associated with indexing, such as transparency and tax efficiency. 

Smaller Wealth Management firms and RIAs may opt to identify an asset manager that offers a robust direct and custom indexing platform and paying a licensing fee to use the technology. From the RIA’s perspective, customization is a way to deliver on their fiduciary duties, and as an asset manager, this provides another revenue stream beyond collecting basis points on AUM. This allows for the smaller RIAs to take advantage of the trend toward direct and custom indexing without having to invest heavily in building out a platform. 

In any implementation model, there are some key features and technological aspects to consider. The tax features are a vital part, as was mentioned above. Not only are investors looking to capitalize on tax losses, but they are also looking for customizable tax strategies. Having nuanced and useful custom-tax features would be attractive to HNW (high-net-worth) and UHNW (ultra-high-net-worth) investors. Other important technological considerations include the ability to offer a wide range of quantitative investment strategies to target specific outcomes, and robust reporting features able to provide a complete picture of performance, risk, and exposure on the individual security level. 

A good platform should allow Advisors to perform all their functions in one, easy-to-use place. This includes, but is not limited to, building, and creating investment templates, tracking, and reporting on the client’s custom index strategies.

Sia Partners has a breadth of experience in the financial services industry, helping clients with the redesign of target operating models, development and enhancement of technology, and assessment and implementation of other operational efficiencies. With the industry’s high focus on technology and digitalization, Sia Partners remains at the forefront of trends through client work and internal research. Specifically, our firm has helped clients assess and roll out transformational technology platforms, including “homegrown” and integration of 3rd party solutions. Additionally, Sia Partners has helped clients roll out new product offerings, including mutual funds, annuities, and other products.

Sia Partners is well-positioned to support each stage of decision making and implementation of these next-generation strategies:

• Assessment of viable options to support the offering, including:

  • Operational assessment: development and implementation costs, development and implementation timeline, ongoing support costs

  • Commercial viability: revenue projections, impact on existing products, market entry considerations, new customer attraction, customer loyalty and satisfaction

• Assistance throughout the development stage, including technology solution design, gathering business requirements, drafting BRD, and testing 

• Support implementation and adoption of technology through the development of policy, procedures, and training

• Capability to support end-to-end process by serving as central Project Management Office, and managing the full process, including roadmap development with key milestones, stakeholder management, and status and progress reporting

Sources

• 40 years after his “folly,” Bogle’s index funds reign

• SPIVA results per region

• U.S. Persistence Scorecard Year-End 2023

• Index funds break through $10tn-in-assets mark amid active exodus

• Why ETFs Seen Soaring 10-Fold to $50 Trillion Will Steamroll Skeptics 

• The Financially Underserved Market: What Drives A $173 Billion Opportunity? 

• Financially Underserved Market Size Study | 2019

• Here’s how to prepare your heirs for the $68 trillion ‘great wealth transfer’ 

• Custom Indexing is THE Investing Mega Trend of 2021.

• Q&A: Build Your Own S&P 500 With Direct Indexing

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  What Is Direct Indexing? 

• How Does Investing in ESG Companies Affect Returns?

• Custom Indexing: The Next Evolution of Index Investing 

• THE NEXT GENERATION OF INDEXING: CUSTOMIZED PORTFOLIOS THAT MEET CLIENT NEEDS