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The Direct Index Domino Effect

Replacing ETFs and mutual funds is only the beginning of how direct indexes will change wealth management.

Domino Effect

 

We’ve previously made the case that direct indexes1 are better than ETFs and mutual funds, and that this will lead to a large shift of assets from ETFs and mutual funds to direct indexes. Even mutual fund companies have told us that “mutual funds are dead” (See Mutual Funds Are Dead and Direct Indexes are Better than ETFs). But displacing ETFs and mutual funds is just the beginning. Direct indexes will also change who manages portfolios, how they are managed — even the core value proposition of wealth managers. 

It all starts with direct indexes replacing ETFs and mutual funds, but, like falling dominoes, each change leads to another: the rise of outsourcing, the rise of total outsourcing, the rise of customization and tax management, and a change in the role of the advisor.

The rise of outsourcing

You don’t reap the tax and customization benefits of direct indexing just by owning the individual stocks. A direct index needs to be managed. It’s too complex for individual advisors to do on their own at scale, so advisors will outsource the job to specialists. 

The rise of total outsourcing

If you embrace direct indexing, you’re buying into the advantages of tax management. But taxes are a feature of portfolios as a whole and proper tax management requires coordinated management of the portfolio. So, if you’re outsourcing the management of the direct index, you should outsource the management of the entire portfolio. There may be a single direct index core or there might be several direct indexes for multiple asset classes, with ETFs and mutual funds for peripheral asset classes. All should be tax managed together, and all of this should be outsourced.2

The rise of customization and tax management

Customization and tax management are not new solutions, but, as a practical matter, they were the exclusive preserve of ultra-high-net-worth investors. They are now becoming a commodity. Once portfolio rebalancing is outsourced, there are no longer barriers to advisors offering customization and tax management to every investor. For example: 

  • Every account can have ESG or religious screens.
  • Every account can have risk customization (e.g. if you work for Exxon, eliminate energy stocks from the portfolio).
  • Every account can have tax-smart transitioning, year-round loss harvesting and risk-compensating gains deferral.

The rise of a new value proposition: the advisor as a financial coach 

Outsourcing the day-to-day management of the portfolio does not mean forfeiting customization and tax management. On the contrary, reaping the advantages of customization and tax management is one of the driving forces behind outsourcing. But outsourcing does do away with old-style value propositions based on trade-by-trade conversations with clients. It replaces the endless quest for market-beating performance with solid, customized, low-cost, tax efficient investing, which becomes a backdrop for the advisor's main role — acting as the investor’s financial coach and guide.


We’ve used the metaphor of falling dominoes to describe the follow-on impact of the adoption of direct indexes. Of course, all this assumes the first domino falls, that direct indexes will, in fact, replace ETFs and mutual funds. The rationale for this is pretty straightforward — direct indexes are customizable and outperform on an after-tax expected basis, and this will create immense pressure for adoption. Everything else follows.

 


1 A “direct index” technically means the investor directly owns the holdings in an index, in contrast to an index fund or ETF, where they don’t. The term “direct index” also includes the case where the investor owns a representative subset of an index. The term is increasingly used more generally to include any model-driven direct stock ownership, even when the model is actively managed.

2 This type of account, when managed holistically, is called a Unified Managed Account (UMA). When a group of accounts belonging to one household is managed holistically, it’s called a Unified Managed Household (UMH).


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