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Direct indexing to herald disruption in ETF marketplace

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Change is coming to the ETF marketplace. ETFs once seemed unstoppable as the fund world’s evolution from closed-end products to open-end mutual funds to ETFs seemed complete. But while the industry continues to rake in an impressive $1 billion each day, some ETF players have become complacent – and their products are ripe for disruption. Shana Sissel, Portfolio Manager, CLS, discusses this disruption.

Given their low costs (zero-fee ETFs hit the market in February) and tax-efficiency, ETFs appear to be the perfect investment vehicles for investors. But they still have vulnerabilities. Namely: ETFs are not tax-maximized. In other words, trade activity isn’t always done in the best interest of tax-sensitive investors. Enter direct indexing.

The great unwrapping

Matt Hougan, CEO of Inside ETFs, calls it the “Great Unwrapping.” A solution for investors who are looking for their own personal index within a certain band of tolerance, using a customized approach to maximize tax-efficiency.

So, what makes direct indexing a better option than ETFs? There are three main advantages to implementing direct indexing in portfolios:

  1. Tax-Efficiency: ETFs are tax-efficient, but direct indexes are more tax efficient. Tax-loss harvesting, gain deferrals, and transition management are all benefits offered by direct indexes that are not available through a typical one-size-fits-all ETF.
  2. Risk Customization: Unlike traditional ETFs, direct indexes can offer investors a better fit for their risk tolerance. Direct indexes can manage around concentrated stock positions, avoid making outsized sector bets, and generally better control the risk associated with the portfolio by setting parameters to meet a specific investor’s needs.
  3. ESG/Social Criteria Customization: As with any rules-based approach, direct-index portfolios can meet client-specific desires to avoid certain industries or seek out companies that meet a preferred ESG (environmental, social, governance) framework.

The direct indexing evolution

Direct indexing isn’t new. Firms such as Wealthfront, Prive, Optimal Asset Management, Eaton-Vance-owned Parametric, and Aperio have been doing it for years.

With almost $100 billion in direct-index assets, if Parametric were an ETF issuer it would the sixth largest and fourth fastest-growing. But improvements in technology have made it possible for new entrants that offer direct-index solutions at lower minimums and lower fees than the legacy firms.

Technological advances have allowed providers to offer direct indexing solutions to a broader array of investors. At CLS we have worked with our sister firm, Orion Advisor Solutions to allow customized tax managed direct index solutions to accounts with minimums as low as $50,000, using Orion’s proprietary optimization solution, ASTRO.

This technology has changed the game for financial advisors who want to harness the power of direct indexing in their portfolios. This trend is just the beginning.

The ETF industry brought innovation and transparency to our industry, and it enabled advisors to better serve investors. As the next evolution, direct indexing will only make us better.

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