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The Mirage of Direct Indexing

Introduction

Direct indexing is hot. In October 2020, Morgan Stanley bought the windfall manager Eaton Vance primarily for its uncontrived indexing subsidiary Parametric. BlackRock followed one month later by purchasing Aperio, the second-largest player in the space. This year, JPMorgan bought OpenInvest in June, Vanguard took over their partner JustInvest in July, and in September, Franklin Templeton uninventive O’Shaughnessy Windfall Management (OSAM) and its Canvas uncontrived indexing platform.

The giants of the windfall management industry are unmistakably intrigued by uncontrived indexing and it’s not nonflexible to see why. The rise of exchange-traded funds (ETFs) has steadily eroded the management fees of bilateral funds and of ETFs themselves, and with increasingly than 2,000 US ETFs and 5,000 US probity bilateral funds all based on a universe of only 3,000 stocks, there is little room left for spare products. The industry is looking for new revenue-generating merchantry areas and growing vendee interest in customized portfolios has not gone unnoticed.

Direct indexing should be an easy sell for the marketing machines of Wall Street: A portfolio can be fully customized to the client’s preferences by, for example, excluding any stocks that contribute to global warming or prioritizing high-quality domestic champions. On top of that, tax-loss harvesting can be offered. And all of this in a fairly streamlined malleate using modern technology stacks at low cost.

Like many proposals in investing, uncontrived indexing seems like a self-ruling lunch that is too good to pass on. But is it?

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An Overview of Uncontrived Indexing

Although firms like Parametric have been offering uncontrived indexing to their clients for decades, the market’s AUM really started to grow since 2015. Over the last five years, uncontrived indexing’s AUM expanded from $100 to $350 billion. In part, this is due to the software-creation technology rhadamanthine cheaper and easier to use, which opened the field to new entrants. The surge has moreover been driven by millennials seeking personalized portfolios, often with a focus on environmental, social, and governance (ESG) considerations.


Assets under Management (AUM) in Uncontrived Indexing, US Billions

Chart showing AUM In Uncontrived Indexing
Source: MorningStar via Financial Times, FactorResearch

How strong is the momentum in the uncontrived indexing space? A market research study by Cerulli Associates in the first quarter of 2021 predictable higher AUM growth in uncontrived indexing over the next five years than in ETFs, separate managed finance (SMAs), and bilateral funds.

Of course, a misanthrope might oppose that uncontrived indexing is not much increasingly than an SMA in a modern technology stack. That may be a pearly point, but it is a discussion for a variegated day.


Projected Five-Year AUM Growth Rates by Product, as of Q1 2021

Chart showing Projected Five-Year AUM Growth Rates by Product (Q1 2021)
Sources: Cerulli Associates, FactorResearch

The Dark Side of Uncontrived Indexing

Direct indexing marketing materials emphasize that each vendee receives a fully customized portfolio. The reprinting might describe a unique, tailor-made, or bespoke portfolio: the grande, iced, sugar-free, vanilla latte with soy milk from Starbucks versus the traditional coffee from Dunkin’ Donuts.

What’s not to like well-nigh stuff treated like a high-net-worth UBS client? Everyone deserves a personal portfolio!

However, this pitch leaves one thing out. What is unquestionably stuff sold is pure zippy management. A vendee who eliminates or underweights unrepealable stocks they consider undesirable from the universe of a benchmark tabulate like the S&P 500 is doing exactly what every US large-cap fund manager is doing.

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But a vendee who creates their own portfolio based on personal preference, plane if a financial tipster manages the uncontrived indexing software, probably won’t be largest at stock picking or portfolio construction than a full-time Goldman Sachs or JPMorgan Windfall Management fund manager. 

Worse, most professional money managers lag their benchmarks over the short and long term, whether they’re investing in US or emerging markets, small-caps, or niche probity sectors. The fees on uncontrived indexing portfolios tend to be lower than for probity bilateral funds, giving them a leg up, but investing based on personal nomination is unlikely to outperform once poorly performing fund managers.

So uncontrived indexing clients should not expect to match the market.


Equity Bilateral Fund Managers Underperforming Their Benchmarks

Chart showing Probity Bilateral Fund Managers Underperforming Their Benchmarks
Source: FactorResearch

The Risks of Tax-Loss Harvesting

While their portfolios may underperform, uncontrived indexing investors still have wangle to flipside important feature: tax-loss harvesting.

Here, stocks with losses are sold when wanted gains from profitable trades are realized, thus reducing the net tax liability. Practically stocks that were sold can only be bought when 30 days without the sale, which ways that an investor needs to buy something else instead.

There are various arguments why the tax goody is far lower in practice than in theory. Indeed, some maintain that the liability is only deferred rather than reduced.

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Regardless, managing an investment portfolio based on tax decisions is wrong in principle and carries significant risks, for example, selling losers at an inopportune time, say during a stock market crash. Typically, the worst-performing stocks rally the most during recoveries. So, if these have been sold off, the investor captures the full downside but only a portion of the upside. Furthermore, replacing losers with other positions changes the portfolio’s risk profile and factor exposure.

But the most hair-trigger specimen versus tax-loss harvesting is that, like uncontrived indexing, it is just increasingly zippy management. Hendrik Bessembinder demonstrated that just 4% of all stocks rumored for scrutinizingly all the surplusage returns whilom short-term US Treasury immuration since 1926. Most stock market returns come lanugo to a handful of companies, like the FAANG stocks in recent years. Not having exposure to any of these in order to, say, maximize tax benefits, is just too risky a nomination for most investors. 


Shareholder Wealth Creation in Surplusage of One-Month US T-Bills, 1926 to 2016, US Trillions

Chart showing Shareholder Wealth Creation in Surplusage of One-Year US T-Bills, 1926-2016, US Trillions
Sources: Hendrik Bessembinder, FactorResearch

Further Thoughts

Investors have realized that zippy management is challenging and thus allocated increasingly than $8 trillion to ETFs. If you can’t write-up the benchmark, invest in the benchmark. This may sound simple and a little boring, but it’s an constructive solution for most investors. 

Direct indexing is the stasis of ETFs and is a step wrong-side-up for investors. Like ESG or thematic investing, it is no self-ruling lunch. Investors need to know that their choices come with a price. Since most investors have underfunded their retirements, they should aim to maximize their returns and stave any unnecessary risks.

Fully customized portfolios have historically been the sectional domain of high-net-worth clients. Perhaps they should remain so.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Aaron McCoy


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Nicolas Rabener

Nicolas Rabener is the managing director of FactorResearch, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on probity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real manor wideness windfall classes. He started his career working for Citigroup in investment financial in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA lease holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

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