What financial advisors should know about direct indexing

Direct indexing is primed to grow at an annualized rate of more than 12% over the next five years, faster than traditional financial products, such as mutual funds, exchange-traded funds (ETFs), and separate accounts. What should advisors be prepared for in the future?

Transcription:

Brian Wallheimer: (00:06)
Welcome everyone. I hope everyone is enjoying breakfast. Settling in, made it through the rain. If you didn't stay here overnight. welcome to invest 2022. I'm Brian Wallheimer editor in chief of Financial Planning, and we're just gonna start things off. Get right into the content today. I know you're all itching to talk about direct indexing, did we have an intro to open our guests. I'll just say we have with us today. Yes, Henry Lao. Vice president of investments at, Mercer Advisors...Tuppence Russo, who is wealth infrastructure at AllianceBernstein and Doug Scott, who is co-founder and CEO of Ethic. Unfortunately Natalie Miller was not able to make it today. She's not feeling well, wish her the best in hope she she's better soon. So, we're just gonna start right off, and direct indexing. We've been writing a lot about it at financial planning lately. We had a cover story on it recently as well, we've seen it go from something that cost, in the seven even eight figure range, nine figure range for people to get into, to something that, there are products out now that you can get into it for just a few thousand dollars, it's evolved. Investor preferences are a big part of that, and it's expected to grow faster than ETFs in the next five years, by some accounts. So I guess my first question is this is really fast. Are there any concerns about where this is going right now or is it all positive?

Henry Lao: (01:45)
Sure. Thanks, Brian. I think it's great, when you think about where the industry has been and where it's headed, this is just another evolution within that arc. So with respect to direct indexing, it really comes down to the technology. It really comes down to scale and it really comes down to bringing that down market. So, as far as growing too fast, that could be a concern. I think last time some really associates made a study there, there was indication that it was gonna grow around 12% over the next five years, annually. So outpacing, ETFs and mutual funds. So I think it's fascinating how, it's moving, but I don't, I'm not concerned at the moment.

Doug Scott: (02:36)
Yeah. I mean, we so for context we build personalized solutions, direct indexing, solutions for a hundred percent of our assets. And so obviously we're very big believers in the strength of direct indexing as an alternative to ETF's mutual funds and other forms of unitized structures. So, yeah the growth is a manifestation of demand. I mean, ultimately the way we think about it. Oh, can you hear me still? Oh, there we go, the way we think about it is it's personalization. How do we think about what personalization action means? and how do we express what's important to clients in the way that we're investing portfolios and, doing that in a much more bespoke way nad direct indexing is the vehicle to which you can, achieve that. And so I think the growth is a manifestation of that demand where especially advisors are looking to find ways to differentiate and connect with clients in unique unique approaches. So yeah, obviously big fans.

Tuppence Russo: (03:31)
Yeah. I also agree with the power of direct indexing. I do think that, there are gonna be some speed bumps along the way. Number one, advisor adoption. I saw a study a couple of months ago that said only 50% of advisors know what directed indexing is. And only 12% are using it. In many cases, this is going to change how advisors run their practice. And if advisors have good practices, they're meeting their client needs, there needs to be a strong impetus for them to change. I also think, as an industry we really need to prove the benefits. So we know what the benefits are, personalization being able to demonstrate your values through your portfolio and the tax efficiency, but we don't do any type of reporting around any of, well sorry, I don't wanna be blanket. I know ethic is very far ahead and there are a lot, there are some, very strong, platforms that are doing reporting, but overall from an industry standpoint, we still report performance. Generally speaking as pre-tax tax efficiency is a huge benefit of this. We really need to move to after-tax to show those that demonstration from a values perspective, the trade offs that you're making, from those decisions, showing that attribution and showing that benefit. We need to move in that direction. I think that's gonna be a speed bump as well, both for advisors and for current clients that are investing in wealth today. And then lastly, and by the way I am a strong believer in this and just, I do think that there's, it's gonna take time to evolve fractional shares to really give it to the mass affluent. It's clearly a trend that many firms are either doing or looking into doing, but there's still a long way that we have to go to make it more mainstream.

Brian Wallheimer: (05:29)
And I want to touch, you talked about that reporting the reporting there. And we talked a bit about that before, we came up here today, what's what's can you expound on, expand on that a little bit? what is it that I mean, I would imagine that people who are syncing, millions of dollars into direct indexing are probably pretty comfortable with, reporting that they're getting. But what is someone like, let's say me who were, if I were interested in going through one of these products to get in for thousands of dollars, what would I not be getting that needs to sort of evolve still?

Tuppence Russo: (06:04)
Yeah. And I think the millions of dollars that are going in, if you look at some of the big players in this space, they are doing after tax reporting, one of the benefits is the tax alpha and there's varying different degrees, but can add one to 2% to your portfolio. Being able to show that on a client report and sit in front of them and say, here was what we did in your portfolio here was your pre-tax, but look at your after-tax performance, that is very powerful. And it's also personalized to that client's portfolio, as opposed to generally speaking at a product or composite level.

Doug Scott: (06:40)
Yeah, from an ethic perspective, we are very technology centric, so all of it is automated. So our ability to reflect tax, reporting our ability to reflect impact reporting, which is a huge element to it, which is what are the things that are important to you when you think about values, preferences, or sustainability or ESG, and how do you make sure that those are personalized in the way you're reporting? And that's extremely important for an engagement perspective, cuz you wanna say, if you're gonna take the energy to personalize something and have that, going through that with a client you wanna show, what are the benefits of going down that approach and what are the trade offs associated with that? And so it's something that we integrate into our user experience. We've had the benefit of building everything over the last, six or seven years in terms of how we can differentiate around that. But it is a massive advantage to be able to show integrated reporting at scale, and again, technology being the underpinning of all of that.

Tuppence Russo: (07:31)
Great. Right. And, just in terms of the benefits, all across the well tech platform and the experience that clients want is around personalization. We've talked about it in the data area, in the client experience and engagement and in the risk tolerance preferences, the conversations that clients and advisors have. This is a next evolution as Doug and Henry said a next evolution, taking it into the portfolio level to really personalize and customize SMAs, for clients

Henry Lao: (08:05)
I think from a reporting standpoint, there's, there's obviously a lot to, lot of room for growth there, but taking a step back, just looking at direct indexing in the space itself. I mean this space is not new. It's been here for over 30 years. It's just given technology, given what toughy said around bringing down costs as a relationship portfolio management from fractional shares to, just low cost trading in general that has really brought it down market. So I think again, highlighting that point and bringing it to the end consumer and the clients and bringing that knowledge base to our advisors is key. So along with reporting, I would say just from a messaging standpoint, to be able to bring that information and knowledge base to our advisors we, at Mercer advisors where we're based in Denver, but we have, we have about 65 offices around the us and all of our advisors are equipped to understand direct indexing because it's really our fastest growing space. we have about 3 billion in direct indexing at the moment. So, for us it's grown faster than again, mutual funds and ETFs.

Doug Scott: (09:21)
Yeah. One of the element to add to that as well, and sort of touch on by both, Henry and Tappi, which is sort of avoiding, if you are gonna personalize something, avoiding the analysis paralysis of just going around in circles of changing and tweaking and all the bells and whistles, and part of that is a user experience or a client experience problem. And that's something that we've found in doing this again and again and again, with many different advisory firms is how can you actually create a streamlined experience where you are not having a big drag on the turnaround time or a big drag around what it means for people to trade off certain preferences on tax, on a factor on sustainability ESG. but having that all integrated in a really seamless way is very, very important at getting adoption quickly. And so we've just seen that in many, many instances and it serves you well to really think about that

Brian Wallheimer: (10:06)
Henry, you touched on the, education aspect of that and making sure that advisors understand it well enough to be taking it out to their clients. What, if you're doing it well at Mercer, what needs to happen in the industry to get this? what, the education component that needs to be the hurdle that needs to be overcome for advisors? Because like you said, it's 30 years old, but it's not something that many clients were working with five years ago. Correct. So what do advisors need to know to start actually getting this out to their clients?

Henry Lao: (10:45)
Why? I think what Doug has brought up here, as far as excuse me, here we go.

Brian Wallheimer: (10:52)
What

Henry Lao: (10:52)
Doug has brought up, around the technology. I think that is first and foremost, key to it's been instrumental to the growth of direct indexing, right? Again, that sound like a broken record at this point, but really bringing it down market. So to answer your question directly around broader adoption, I think when it comes down to education, it's understanding how to connect the dots between a tax optimization, with personalized investing that can, adapt with personal values and then be able to tie that down to, cost and efficiency and then streamlining it through technology. So, as far as the education process, it's understanding, how that will ultimately help the end client. So once they can see that concrete value that it brings. So speaking to tappi's reporting, I think once that comes into light, I think that will really drive the next iteration of this growth.

Tuppence Russo: (11:59)
Sure. I think the evolution at some point client, well, I'm speaking in blanket statements, but there's going to be more client demand and client demand is going to be prompting the advisors when clients are coming to their advisors and asking them how they can have this product, how they can show their values through their portfolio, how they can reduce their tax bill or optimize or, charitable gifting, whatever the case may be. I think coupled with the push to advisors on adoption and the benefits that it has for clients over time, clients are gonna be as well, really asking for this and putting the pressure on advisors.

Doug Scott: (12:38)
Yeah, well, something we've seen is just, it's a unique opportunity for an advisor to connect more deeply with a client. That's kind of what it comes down to. So in terms of the impetus for advisors to think about education or understanding as Henry and Tubby said around whether it's tax or values, everything else, it's really driven at driving a better client experience and better client outcomes and a way to connect on a deeper level. And so we've just seen that as being such a success factor as Henry pointed out with Mercer, but we've seen this in so many different ways where if you can, if you can overcome just the understanding of what the product is, how it's different, how you position it, how you think about, educating in the moment as well. Because one of the things that's different is if you have an ETF for a mutual fund, you have a very finite sort of story to tell around that particular product with this, it's all different. So the ability to be adaptable, and this is where the user experience comes in, which is how do you integrate education? If there's something different that a client wants in the moment, how do you adapt to understanding how to address that? And so there's more of a real time nature associated with positioning direct indexing, which again goes back to this whole sort of how do you integrate technology, which is the way, we think about it in sort of the position from ethic perspective.

Henry Lao: (13:45)
Yeah, I think that's a great point, Doug as far as the adaptability, it brings that story that clients would love to hear, right? To be able to say that this is their portfolio, that this is something that's personalized to their values and their unique circumstances. And then it comes through with a after tax alpha that boosts up the entire story. So from a being able, a tangible performance perspective, I think that's important, right. That delivers real economic value right off the bat.

Doug Scott: (14:21)
That' great.

Brian Wallheimer: (14:23)
So one of the other things we talked about was who this is right for right now and how that's going to evolve. I mean, who are you rolling this out to, today and how is that gonna change in I don't even know like how fast this is gonna happen. Is are we talking months? Are we talking years? What's sort of the short term and long term outlook on when this gets to clients, which clients, those sorts of things.

Doug Scott: (14:49)
I'm happy to talk a little bit, go ahead. So we serve about just for context, we have grown very rapidly. We've sort of, in the last couple of years, we've now serve about 125 different firms across the country across about 1.8 billion. As I mentioned, all personalized directing index solutions and growing extremely quickly, because what we see this is primarily those firms are serving high net worth ultra high net worth sort of the multifamily office space and above. But part of it is the constraints like Toppi mentioned around fractional share capabilities for most of the major brokers. So as those share, as those capabilities begin to more meaningfully roll out and the coverage increases in all of those things, there's no reason why you couldn't take this down to fractional very small retail client accounts which is but part of the challenge with doing that is actually not just on the way you, sort of invest, but actually the whole user experience, like, is it right to have a personalized retail account if you are trying to serve that as advisor every single time? Yeah. So part of it is actually the positioning for the firm is what is right for the firm. So we've seen examples where, we've done positioning, not just at the end client level, but actually at the firm level. So a firm's taken a perspective on it. And then what you're essentially doing is we like to think of it as like last mile personalization. So just tweaks and changes once you have the basis set up pretty well. So you're not just doing wholesale changes with every single client. So there's a kind of a technology problem. There's a sort of a fractional share capability problem, but there's also just the positioning within the firm and how you actually are practically delivering that solution and distributing that solution.

Tuppence Russo: (16:20)
Yeah, I would add to that changes in the operating model and operational and servicing burdens. There's varying degrees of what advisors are using right now to build portfolios. Some are not using SMAs at all. Others are using SMAs direct indexing could come with hundreds of securities in one portfolio. That's more corporate actions, more proxy voting, more, lumpier tax filings, for both the firm to produce and the client to file. there's more questions around individual securities within portfolios. And then of course the performance reporting, that we've talked about, making sure that you can do performance reporting for three, 400 securities versus, an index to show the benefit, so there are a lot of different things to consider on whether it's right for your firm trade offs and your practice, or an advisor's advisor's practice.

Brian Wallheimer: (17:23)
And Henry, I wanna give you a chance here real quick, but I want to ask real quick on that when you talked about that the trade offs, is that a technology problem that can be solved or is that just a conversation with a client or, is that a hurdle that can be overcome or is there just a point at which there's a lower bound in which we have to say this doesn't work for the amount of money you're, you're interested in investing?

Tuppence Russo: (17:47)
I would say both, I think given the right resources and investment, there's a lot that technology could do for this, but, there will still be a servicing, burden and more, information flow, and operational support for it. And I think it, again, as everything that we do, it's how do we meet clients' needs meet them where they wanna be met. And some of them just want one single security, an ETF line on their brokerage statement. Others want more if ESG or shareholder activism, or it's an IRA portfolio where tax efficiency, maybe isn't right for that client, maybe you don't wanna take on that cost or that servicing burden, but for a client in the highest tax bracket that has a long time horizon for investment, that is very important for them to make an impact through their investments. That is a client that direct and indexing, is a perfect fit for

Doug Scott: (18:54)
I'd say just like, it's not a technology problem. So in the context of the technology is scalable all the way down to really tiny accounts. It's more a question of what is right for a firm and the clients that they serve. And how do you want to position that? So if you're doing direct to retail business, that's an entirely different type of, client service model. So it's really trying to right. Find the right fit and balance. As I said, the big element around it is how you position it, how you think about it in the context of the asset allocation. How do you think of it in the context of wanting to have that personalized client experience? Where do you want to have this on that sort of journey, the client journey? So that's what we see is really that that's the part you gotta get really, right? It's not a technology we can do that. We can build it all the way down. As I said, there's some limitations on fractional share capabilities, which is just a portfolio management constraint, but over time, those will go away and you can actually distribute all the way down. Yeah, sure.

Henry Lao: (19:50)
I think those are great points, when you think about who this who this solution would be appropriate for, that is direct indexing. When you look at the client profile, a lot of that is dictated by the practice itself. So you have to ask yourself, when you look at your practice, is it fundamentally made up of mutual funds and ETFs, and that serves your client base great. That can continue to be the case, but I think this would be another, opportunity to really bring home the story of customization. But at the same time, you do have to balance the cost between operations and scalability. So for us being able to have a team of basically within our investment department of 45 people it really encompasses from operations to trading, to portfolio management, all the decisions that you have to make at those different points of the overall process. So it's not really a technology problem. It's really a balancing between scale and operation. So, being able to bring that down market with technology has really moved the space forward, but I think going forward, depending on how your practice is structured and what your advisors are currently delivering to that specific client base will determine your opportunity set. I think that opportunity Set though, A lot of that come just by way of increase sensitivity to taxes, right? So whether it's a different regime or whether it's a different economic policy change that could obviously dictate a lot of how client behaviors, will be driven going forward.

Brian Wallheimer: (21:39)
Great. we're getting close to the end here. And I learned as a journalist many years ago that the most important, and the best question I can always ask is what didn't I ask you that you still want to talk about? Are there any points to make here that we haven't touched on yet?

Doug Scott: (22:00)
The take away from, my point of view, the main one I would say is this integrated education? There's a tax component, there's a values component. And this is, as I said, like the part that really resonates when, when we partner with firms is how effective this can be as a leveraging connection point to deepen relationship with the client. And if you can position it well, direct indexing can be really additive in that way, but in and itself, just as an investment product. Yes. There's some definite benefits, but it's really about how effective you implement it, like to Henry's point. So, no, I think we covered a lot of territory, but yeah, I just emphasize that.

Henry Lao: (22:39)
Yeah. I think the takeaway would be just asking yourself when you look at, when you look at the space itself for direct indexing and where the opportunities are for your clients, does that align with the nature of your business? And if it does, then there's obviously some opportunity, but understand that from a Broader perspective, that it's gonna continue to really grow. So depending on your marketing story, That may also determine whether or not you want to include it.

Tuppence Russo: (23:16)
So I guess I'll add then direct indexing is a really powerful tool to every, for everyone to have in their toolkit, from the front to back experience, engaging with clients in a deeper way to the investment portfolios and the returns that clients can have, and the technology, has made it scalable and so definitely something to, consider, keep in mind and watch.

Brian Wallheimer: (23:45)
Great. Well, I wanna thank you all for coming out today. I wanna thank the audience for your attention and your time. I'll give you a few minutes back before we move on to our next panel, but let's give them a round of applause.