On February 24th, the CFA Society of Chicago Education Advisory Group welcomed two experts in the field of direct indexing. Joining in the panel discussion was Natalie Miller, CFA, Director of Investment Strategy at Parametric Portfolio Association. Secondly, Chris Meredith, CFA, Director of Research and Chief Investment Officer at O’Shaughnessy Asset Management’s. The panel discussion was moderated by Ben Johnson, CFA, Head of Client Solutions at Morningstar.
Direct Indexing is a subject matter that has gained popularity in the investment world. However, with respect to total asset undermanagement, direct indexing is still in its early innings. Many in the investment world view direct indexing as the natural next evolution similarly to the transition from mutual funds to exchange-traded funds (ETF’s). The promise of low fee, mass personalization and most importantly tax alpha is a compelling proposition to a growing portion of wealth managers.
Here is a summary of the questions and answers that were discussed in this dynamic and educational conversation.
Terminology, when investors using the term direct indexing what do they mean and to what extend is it related to indexing?
Natalie Miller, CFA
At its core direct indexing is all about customization. Direct indexing involves ownership of the individual securities in a separated account. At its heart the ownership of individual securities enables a host of benefits such as tax management, ESG consideration and factor exposure. The combination of these benefits enables direct indexing to provide benefits beyond traditional indexing. To that extend direct indexing can be indexing, but it can also be much more.
Since the advent of mutual funds, investors have had immediate access to diversified portfolios to what extend is direct indexing a continuation of this trend and what are the factors that have enable direct indexing accessible to investors?
Chris Meredith, CFA
The key aspect is technology. Technology is enabling has made it much more efficient to access all the date. Also, transaction cost has come down considerable. Mutual funds are limited in customization and have tax disadvantage characteristics. Exchange traded funds provide some benefits regarding tax management. Nonetheless, with lower trading cost direct indexing enables further advancements in tax management and mass customization.
Is direct indexing more of a software capability rather than an investment capability?
Natalie Miller, CFA
It is both, technology enables ease of use and efficiency of direct indexing. Direct indexing is a science and an art. The science part is the technology but there is also a human aspect and a human insight to think around optimization changes.
Chris Meredith, CFA
Risk modeling has advanced considerably over the last 20 to 30 years. Risk modeling can extract more and more factors that contribute to systematic risk. Yet implementing that in risk modeling in practice that is a bit of art. Some clients might wish to limit the number of securities to 50 names, this requires trade-offs. The portfolio management human aspect involves harvesting losses and the management of wash sales.
What is direct indexing benchmark to and how to clients determined success?
Natalie Miller, CFA
Many clients have custom benchmark depending on the tilt exposure clients’ desire. A custom benchmark is calculated based on exposure. The returns are shown on a pre- and post-tax standpoint. On an after tax return the tax management is highlighted to showcase value. Another important aspect is the qualitative and quantitative aspect. One thinks about the qualitative ESG considerations. For example, a ESG client can without tobacco exposure can see the reduction in smoking packs produced.
What guardrails are in place to ensure client gain proper investment exposure given mass customization capabilities such as over exposure to momentum or what have you?
Chris Meredith, CFA
One of the innovations to the firms is platform capabilities related to custom indexing and the integration of user interface (U.I.). This UI allows clients to dial up or down factor preferences. Within the system there are logics that reference the tracking error goals.
It seems like tax management benefits are still the core benefit of direct indexing and some of the ESG considerations are a distant second can you discuss how tax management can be fully utilized?
Chris Meredith, CFA
The beauty of tax management is we can harvest losses when markets go down. When market go up this is harder but remember that when you have cash there are new cost basis that are now candidates for harvesting. As investors with cash buy into securities even in up markets there will be harvesting opportunities. Alpha tends to be more sporadic as appose to tax management that is more tangible.
Natalie Miller, CFA
Yes, tax benefits are front loaded to the first several years given the tax loss opportunities. But there are still benefits even past that and the tax management process continues. Cash investment on an annual basis almost resets some of those tax lots. Also if a client is charitable inclined there is also an opportunity to gift high return securities.