Will robos help direct indexing topple ETFs?

Direct indexing was nothing new, until the robos got involved.

Sometimes known as custom indexing or self-indexing, the idea behind direct indexing is to replicate the performance of an index fund by buying the underlying shares instead of an ETF or mutual fund – the primary advantage being tax efficiency.

The basic strategy has been around for decades as a more tax-efficient alternative to index-based mutual funds and ETFs. Until recently, direct indexing was only available to the ultra-wealthy due to the intensive manual labor involved.

Digital advice is changing that. Thanks to recent improvements to automated rebalancing technology and new custodians designed to accommodate fintech platforms, robo-advisers are commoditizing direct indexing and bringing it down market.

Wealthfront was an early entrant, adding direct indexing to its service in 2013 for retail investors with at least $500,000 on the platform. The firm has since lowered the minimum to $100,000, according to spokeswoman Kate Wauck.

More recently, robo startups like RobustWealth and Smartleaf have made direct indexing a central feature to their adviser-facing digital advice platforms. Parametric, a pioneer in direct indexing that used to reserve the strategy for clients with a net worth of at least $100 million, now has a technology offering, Custom Core, that brings the minimum down to $250,000. These platforms generally make money off direct indexing by charging advisers basis-point fees on the assets they bring onto the platform.

Proponents like Smartleaf president and co-founder Jerry Michael say making direct indexes practical and affordable for mass affluent investors creates “a superior alternative to ETFs for most investors,” arguing that they have higher after-tax returns and are cheaper to launch and maintain.

RobustWealth founder and CEO Michael Kerins believes direct indexing will soon be a big trend, and compared it to how ETFs disrupted the mutual fund market. If it can attract enough interest among advisers, Mr. Kerins believes, it could potentially threaten the existing market for fund providers.

“[Direct indexing] can disintermediate ETFs to a certain degree,” Mr. Kerins said.

HOW IT WORKS

Instead of buying an ETF that tracks the S&P 500, for example, an investor would buy shares of the 500 companies it tracks. Doing so is too cumbersome for most, so direct indexes typically include just enough of the shares to match the index’s performance and risk while minimizing tracking error.

Mr. Kerins said that replicating the performance of the S&P 500 really only requires owning 50 or 100 of the underlying stocks. By owning a number of shares instead of a single ETF, the investor has more opportunity to harvest losses or defer gains.

“If you buy the ETF, you can only harvest losses on one security. If I buy 150 stocks to track that [index], then I can harvest losses on all 150 stocks,” Mr. Kerins said. “The more stuff in your portfolio you have moving around, the more opportunity you have to harvest losses.”

Smartleaf claims that a five-year back test found direct indexes added 1.93% in tax alpha per year compared to ETF counterparts.

The advantages are more striking when transitioning a legacy equity portfolio into an index. ETFs require liquidation of existing holdings, which Smartleaf’s study found would cost an average of 7.21% of portfolio value in taxes. Transitioning to a direct index (in a tax-sensitive manner) would cost an average of 0.21%, according to Smartleaf.

The other major benefit is around portfolio customization. An adviser can easily remove shares to meet a client’s demands for socially responsible investing while still tracking an index. Or if a client works at a company that offers stock, direct indexing would let the adviser reduce exposure to those securities.

FORWARD-LOOKING

Michael Kitces, partner and director of research at Pinnacle Advisory Group and co-founder of the XY Planning Network, has been covering the possibility of what he calls “Indexing 2.0” disrupting the ETF marketplace for some time. Back in 2014, he predicted that we could be on the cusp, but noted a few challenges.

The first was that rebalancing software would need to improve to handle the large quantity of investment positions held in model portfolios. The other was the transaction costs on traditional custodian platforms. Both problems, Mr. Kitces said, would be eliminated in a matter of time.

Once these problems are solved, Mr. Kitces said, advisers should be able to build a portfolio in just a few clicks that would contain the same underlying securities as one consisting of various index and sector funds, only without the actual funds. Mr. Kitces said this would allow “for a more granular level of ownership that provides the potential for a more refined level of tax harvesting” and “potential cost savings on fund fees.”

ENTER THE ROBOS

Mr. Kitces was describing in 2014 almost exactly the product Mr. Kerins is currently pitching to RIAs and asset managers. Advisers can log on to RobustWealth, select which ETFs they want to purchase, and the software will instead automatically create a direct index and invest the funds into the underlying securities.

“It’s just as easy as buying an ETF,” Mr. Kerins said.

Advisers can upload investment models to be recreated, or build their own. Mr. Kerins also hopes to partner with asset managers to recreate their models using direct indexing, eliminating the need to buy funds from a provider like BlackRock, State Street or Vanguard.

Mr. Kerins says in addition to developing the software, direct indexing is made possible by a partnership with Apex Clearing, which supports the scale the technology requires and doesn’t charge advisers a trading fee.

Wealthfront, RobustWealth and Smartleaf all use Apex Clearing. Apex charges firms a basis point fee on the assets they custody with them. Their other services are wrapped into that fee.

Several of the automated direct indexing platforms, including Wealthfront, RobustWealth and Parametric’s Custom Core, require minimums of at least $100,000 to avoid fractional shares. But Apex also supports fractional shares, which Smartleaf has taken advantage of to offer direct indexing to even smaller accounts.

SKEPTICS REMAIN

Betterment’s director of behavioral finance and investments, Dan Egan, is intrigued at direct indexing’s potential for customization and disintermediating the fund providers, but says it’s not a high priority for Betterment.

“For most people, the value of aggressive tax-loss harvesting isn’t that great,” Mr. Egan said, adding that asset location was a higher priority for the company because it works across Roth IRAs and 401(k)s. “From a financial planning and investment management point of view, giving something that adds tax alpha across both of them was far more powerful. That’s the issue with direct indexing – it’s limited to taxable accounts.”

Mr. Egan said there could be hidden costs to direct indexing, including larger bid-ask spreads, and that higher tracking error is riskier than direct indexing proponents admit. There’s also a chance to create new conflicts of interest.

“Something I would be suspicious of: if an adviser doing something like this is compensated for order flow,” Mr. Egan said.

(More: Look out BlackRock and Vanguard, Fidelity files with SEC for six smart beta ETFs.)

The large ETF providers also don’t seem to feel threatened by a rise in direct indexing. BlackRock and State Street both declined to comment. Vanguard spokeswoman Carolyn Wegemann said the company has examined the concept over the years, but “ultimately concluded that we are satisfied with the construction methodologies, objectivity and credibility offered by independent index providers, coupled with the reasonable cost arrangements that we’ve negotiated on behalf of our clients at this time.”

“There are also costs, data and regulatory issues associated with self-indexing, such as the need to obtain exemptive relief,” Ms. Wegemann added. “We will continue to explore any means of lowering the cost of investing for our shareholders that doesn’t sacrifice the integrity of the fund.”

TIME TO WAIT?

Despite writing about the potential benefits of direct indexing and forming an official partnership with RobustWealth to launch a turnkey asset management platform for the XY Planning Network, Mr. Kitces says he isn’t looking to push a direct indexing solution. He said it doesn’t make sense given the average size of XYPN client accounts.

“There’s still a floor which [direct indexing is] just not very economically practical and useful, at least until fee-based wrap account costs come down even further,” Mr. Kitces said.

Again, it still just seems like a matter of time. The tax code favors a low-cost, automated solution to direct indexing, and Mr. Kitces said the ease of adding customized client portfolios on a robo-adviser eliminates the need for many active-management middlemen.

“In fact, arguably this is the real ‘billion dollar idea’ that robo-advisor platforms should be trying to tackle,” Mr. Kitces wrote on his 2014 blog. Not only would it make robos more relevant to investors, it would create new competition for the multi-trillion dollar mutual fund and ETF industry. Only robos would have the advantage of being able to offer investment products directly to consumers and advisers.

It could be that the real threat of robo-advisers wasn’t a replacement to human advisers, but as a disruptor for the ETF marketplace.

Related Topics: BlackRock Inc., Vanguard Group