Jenna Dagenhart:

Hello and welcome to this Asset TV Direct Indexing masterclass. Many advisors use direct indexing strategies for their tax advantages and personalization possibilities. Today we'll cover how direct indexing differs from an index mutual fund or ETF, what to look for in a provider, some of the recent innovations in this rapidly growing space and much more. Joining us now, it's an honor to introduce our panelists. Brandon Thomas, co-founder and co-CIO at Envestnet, Kevin Maeda, CIO of Direct Indexing Strategies at Natixis Investment Managers, Manju Boraiah, Head of Custom SMA Investments at Allspring Global Investments, and Natalie Miller, Director of Investment Strategy at Parametric.

Well, everyone, it's great to have you with us and kicking us off here, Kevin, what is direct indexing and how does it differ from using an index mutual fund or ETF?

Kevin Maeda:

Sure. If we think about an index mutual fund or ETF first, I think people are mostly familiar with those where they're commingled vehicles and when you're buying one of those, really what you're doing is you're buying a share class of a structure that then in turn buys individual stocks. With a direct index though, that's a little different because instead of owning a share of a fund, you own shares of individual securities directly, and this allows investors to do some other creative things that we'll talk about later. But essentially you're building your own mini index portfolio.

Jenna Dagenhart:

Now, Brandon, there's been a great deal of talk about personalization. What types of customization or personalization can be applied to direct index strategies?

Brandon Thomas:

Yeah, that's a great question, Jenna. It seems that there's an emerging distinction between the terms customization and personalization. Customization is really a bread and butter staple of most direct index providers as well as traditional SMA managers for that matter. And when we say customization in regards to direct index strategies, we typically are referring to two different aspects. One is tax management, and the second is some type of account restriction such as security sector or country restrictions. Customization is typically applied to an existing strategy of a manager. For example, an investor may be seeking to invest in a manager's US large cap core direct index strategy and then have the manager optimize the strategy for tax purposes. The client may also ask the manager to restrict the portfolio from holding certain securities. Perhaps the client works for a publicly traded company and owns the stock directly and doesn't want any additional exposure to the stock.

That's customization. Personalization is a newer concept and takes the idea of customization a step further. In a personalized direct index strategy, the investor can build a bespoke portfolio from scratch and specify dozens of different types of dimensions they wish to include in the strategy. For example, the investor could construct a US all cap strategy that is tax optimized and contains security restrictions, but which also includes single or multi-factor tilts, a dividend yield focus, ESG integration, impact restrictions, and incorporation of other types of thematic exposures. There were literally dozens and dozens of different investment and operational preferences. The investor can express any personalized strategy. In addition, this type of personalized bespoke portfolio can be constructed around legacy positions that the investor prefers to retain and bring into the portfolio. So personalization and customization go hand in hand. Personalization is a little bit more granular and more customized and a portfolio can be created unique to that particular client's preferences.

Jenna Dagenhart:

Manju, turning to you, what are some of the recent innovations in direct indexing?

Manju Boraiah:

Sure, Jenna. If you think about the concept of direct indexing, the concept has been around for decades, but what has recently happened that it's become more accessible to an average retail investor as the fees and the account minimums have actually continued to drop. There are three factors that I think that are leading to this change. One has obviously the advancement in technology, the zero commission trading, and then also the advent of fractional shares. The advent of fractional shares, especially in my view have actually democratized direct indexing for a vast array of retail investors, especially in the lower echelons of the wealth spectrum. By dropping the account minimums to just a few thousand dollars. So the concept as Kevin explained to quantitatively build a low cost customized portfolio and systematically tax manage them at lower minimums, I think has opened up a whole host of avenues for FAs and their clients.

There are two recent developments that I actually want to highlight that I feel pretty excited about in this space. One is essentially the concept of direct indexing being applied to fixed income. Direct indexing and fixed income doesn't really mean that you're tracking an index. It's really building these bespoke ladder portfolios and munis and tax focused income, mainly investment [inaudible] and customizing that based on a few metrics. It could be credit quality or maturity or duration or sometimes even income. The second direction of travel, especially in equities, is really the concept of combining factor enhanced portfolios with thematic tilts. So as Brandon explained earlier, factors have been around for a long time, so tilting a portfolio to either one factor or multiple factors, be it quality, value or growth has been done on the institutional side and more recently on the retail side. And the concept of thematic tilts has also been around for a long time. So you can tilt your portfolio into either sustainable tilts, could be a climate tilt or an energy aware tilt and things like that. Or it could be a mega trend like robotics or energy efficiency. So tilting portfolios into themes that have also been around, but combining factor tilts and thematic tilts in the same portfolio is actually quite interesting. In my view, it actually opens up more avenues for investors to customize and express their objectives in a different way.

Jenna Dagenhart:

Certainly some exciting innovations and we'll speak more about those later in the program. But before we get there, Natalie, how would you describe the direct indexing landscape today?

Natalie Miller:

Well, direct indexing certainly is in the news more as there's more providers coming to market and that increase in publicity and the number of providers should lead to higher awareness among advisors and investors. And I think that that aspect of personalization or customization is driving a lot of that interest in growth. Investors want the same level of customization in their investments like they do in their coffee order, for example. There was a study by Cerulli in late 2022 that estimates that the annual growth rate for direct indexing will be 12.3%, which is more than the estimated growth rate for ETFs and mutual funds. What that means to me is advisors need to get comfortable with direct indexing, talking about the benefits of direct indexing and personalization and that tax management can provide to their clients. What's interesting is that same study found that currently only about 14% of advisors are aware of and recommend direct indexing to their clients even though more than half of those advisors serve clients with more than $500,000, which is an account size that could best benefit from all that direct indexing has to offer. Differentiation is increasingly challenging for financial advisors and wealth management firms. Adding the ability to customize portfolios either for taxes, personal beliefs and values or a unique financial goal gives advisors a way to create a unique client experience to help them stand out from their peers.

Jenna Dagenhart:

Kevin, how should one choose between using a direct index index mutual fund or ETF, and what are some of the benefits of using a direct indexing structure?

Kevin Maeda:

Sure. I think some of my colleagues alluded to some of this before. We'll be a little bit more explicit with this. With a mutual fund or ETF, typically the minimums are extremely low. So sometimes $100 for example for just one share of an ETF. And so this allows an investor to access equity markets that are and become very diversified at extremely low minimums. With direct indexing strategies, typically they do have larger minimums, oftentimes 100,000 or 250,000 and larger. And a lot of that is because of purchasing those individual stocks directly. And in order to buy enough stocks to have a properly diversified portfolio, you need enough assets to back that as well. Now Manju mentioned that those may be coming down as well with the advent of fractional shares, but then Natalie also pointed out correctly that the largest tax benefits come from those larger accounts and typically investors in higher tax brackets.

So there's kind of a trade-off for both the benefits of having access to this, but also benefiting from the main and most common advantages, which are on the tax side. For customization or personalization reasons, people might still want to use the strategy even at very low minimums or even in non-taxable accounts. But really I think the main considerations people are looking at using these currently are primarily for those tax benefits. And so from that standpoint, usually the minimums aren't inhibiting those high net worth investors from accessing this. It remains to be seen whether the mass market or lower end of the market would really benefit as much and if that would provide as much growth to the industry as well.

Jenna Dagenhart:

And then I have to ask, what about some of the downsides?

Kevin Maeda:

Sure. Yeah, that's only fair. The downsides of direct indexing, I'd say the biggest downside would be cost. Typically it does cost more to implement a direct indexing strategy than to use an ETF or mutual fund. In fact, you can get some index mutual funds for zero basis point expense ratio now. That's pretty hard to beat, right? With direct indexing, it does cost more to implement because you are requiring a relationship typically with a financial advisor, and they will work through an investment manager, either proprietary or non-proprietary, to implement those strategies. There's a lot more challenges on the operational side and trading side for these strategies as well because you have to keep a proper account of all the cost basis and tax lots. So there's more complexity in the background. Over time, it's possible that those expenses will come down as technology improves, but for the most part I'd say the expenses and the minimum sizes are probably the most challenging downsides to using direct indexing over an ETF or mutual fund.

Jenna Dagenhart:

Brandon, are there any disadvantages to investing in direct indexing strategies?

Brandon Thomas:

Well, Jenna, really from a theoretical perspective, there really are no disadvantages to investing in direct indexing strategies when you compare them to either actively managed SMA strategies or index mutual funds and ETFs. Compared to actively managed SMA strategies, direct index strategies are much lower cost. Kevin just pointed out that yes, there are going to be higher costs than ETFs or index mutual funds, but a lot of times investors are making the decision as to whether to go with an actively managed strategy, whether it's a mutual fund or an SMA, or a direct index strategy. And there are reasons to go with a direct index strategy beyond just the cost, but they are much lower cost, sometimes 50% or 75% lower cost than an actively managed strategy. And they usually have more consistent performance characteristics than an SS actively managed SMA.

So we see a lot of investors and their advisors opting for direct index strategies when they're making the decision between actively managed versus direct index solutions. And then compared to index mutual funds and ETFs, Kevin and Manju and Natalie all pointed out some of the disadvantages there. They are a little bit higher cost than these ETFs, but you don't get the true personalization that you do with ETFs in index funds. And while ETFs can be very tax efficient, you can really target your tax management within these direct index strategies. I think the big disadvantages come on the operational side and Kevin, Manju and Natalie have all pointed these out. From an operational perspective, fractional share trading, there's a lot of promise there, but it's not very common yet. So for certain investors, account minimums, which typically range ... In terms of direct index strategies, they range from 100,00 to 250,000. That can pose issues.

I mean, that's a hurdle that some investors just can't overcome. But really one of the only pushbacks that we hear from investors is around the number of positions held in these strategies. Depending on the type of strategy, the portfolio can hold 200 to 300 positions. And this can be a change for some investors who may be used to holding only a handful of ETF positions and they may be wondering, why am I owning one or two shares of this stock that's in the portfolio. But we're almost always able to convince those investors that owning more positions is an advantage, both in terms of lowering the tracking error and then providing tax management opportunities as well. So from our perspective, there aren't any fundamental disadvantages, but there are some operational hurdles that often need to be overcome.

Jenna Dagenhart:

Natalie, is there anything that you would like to add about the pros and cons of direct indexing?

Natalie Miller:

Yeah, I think feeding off of what Kevin and Brandon mentioned that directing indexing is expensive and it can be complex, but it's up to the advisor to demonstrate how those long-term advantages of direct indexing may outweigh the upfront costs from a customization perspective, from an after tax perspective. And then on the complexity side, I think that with the right direct indexing provider, investors, even if they're owning hundreds of shares of individual stocks rather than just a handful of ETFs, they should have access to simplified reports that bring to life why they're invested in that direct indexing strategy in the first place.

Manju Boraiah:

So just adding to all the points that have been made, Jenna, the one challenge ... I should say it's a hurdle, not really a disadvantage in direct indexing is really the concept of education. When I've traveled the country meeting the FA teams, the penetration, especially in some of these larger FA communities with direct indexing is really low. If you look at the Cerulli Associates survey, I think the number of FAs who have actually heard of direct indexing and in fact embrace direct indexing is really low. It's less than I would say about 25%. And the number of FAs who actually allocate to direct indexing in any significant number anywhere north of 10%, that's even lower. So the primary challenge for all of us is really around education. So really bringing the concept of what direct indexing is. Obviously this masterclass is going to help FAs understand what the pros and cons are. But just spreading the word, just helping them understand where the advantages are, where the benefits are. I think that to me continues to be a hurdle for adoption.

Jenna Dagenhart:

That's a great point about the importance of education, Manju. And sticking with you here, direct indexing is sometimes referred to as in all season strategy. Could you explain that for us?

Manju Boraiah:

Sure. Yeah. If you think about what an all season or all weather strategy is, it's essentially an investment strategy that typically performs consistently well in different macroeconomic regimes. So be it the one policy regime or growth regime or inflation regime. So if you think about direct indexing as a investment strategy, as everybody has explained, it's a relatively low cost solution that's designed to consistently achieve certain objectives, be it financial objectives or value objectives. So the one feature of direct indexing that's inherent to its design is the concept of algorithmic tax management or systematic tax management. From my perspective, systematic tax management is an all weather or all season strategy. The reason is you can harvest losses and offset your gains at any point in time throughout the year and in any macroeconomic regime. So as regimes change, going through different macroeconomic cycles, having the direct indexing portfolio where, as Brandon pointed out, you have a number of holdings ranging anywhere from 200 to 600 at times, depending on the benchmark that you're tracking. You have more opportunities to harvest losses in one part of the portfolio that you can use to offset gains in other parts of the same portfolio or in other portfolios within the asset allocation mix of that investor.

So to me, I think that adds a great advantage to investors to use direct indexing strategies as a way to enhance their after tax returns. The other advantage is around customization. So customization in general can help advisors and their clients position portfolios to be well performing in certain regimes. So you can either position the portfolio to just passively track an index and add exclusions or you can exclude individual stocks or sectors that you think will underperform in certain macroeconomic regimes. The other advantage is you can add factor tilts. So you can add one factor or multi factor tilts to these portfolios so that you can potentially outperform the benchmark in different macroeconomic regimes. So the combination of systematic tax management and the flexibility that the customization provides to reposition your portfolio in a certain way as you go through regime changes makes direct indexing, in my view, a fantastic all weather strategy.

Jenna Dagenhart:

What about portfolio transitioning, Kevin? What is portfolio transitioning and how does it work?

Kevin Maeda:

Sure. This is something that you can't really do with ETFs or mutual funds, but imagine a situation where you have an existing portfolio of stocks. It could be 20, it could be a hundred, it could be 150, it doesn't really matter. But you might have this basket of securities and it could be coming from a separately managed account or an active strategy, and you're not quite sure what to do this. And a lot of times what a financial advisor's only option is is to liquidate the portfolio and start fresh rebuilding a portfolio for their client, whether that's with other SMAs or ETF models or something else. When you do this, it's very possible to realize a large capital gain. Perhaps you have purchased these securities from a long time ago and they've appreciated quite a bit. And so what direct indexing does is it allows you to bring those securities into a portfolio and then to slowly migrate them toward an index over time.

That can typically be done with a capital gains budget, for example, where you're transitioning only a certain amount each period so that you nudge the portfolio in the direction that you want, but with control over capital gain realization regarding how much gains to realize and the time period which you want to do that. Now some people might want to transition immediately, for example, but that might come with a lot of capital gains. Other people might want to instruct to transition portfolios only to the extent that they can offset them with losses, for example. And this might take a very long time to then transition toward an index, but at least it allows the client to have very finite control over their tax situation. So this is something we see probably about half of our clients do is they fund portfolios with stock and have us transition those portfolios over some specified time period for them.

Jenna Dagenhart:

Manju, why is direct indexing an effective tool to help clients transition portfolios efficiently in a tax aware fashion?

Manju Boraiah:

Sure. As Kevin pointed out, one of the key advantages of direct indexing is the tax management and the taxable transition. The tax efficiency that that's kind of inherently baked into the design of direct indexing, I think that plays a huge role. So the concept of breadth. So as direct indexing portfolios have a ton of holdings in them, depending on the index they're tracking, it provides more flexibility when you're doing taxable transition to essentially, as Kevin pointed out, either transition the entire legacy portfolio or pieces of the portfolio, a portion of the portfolio through time. So you have more holdings that you can leverage to actually transition things in a much more tax efficient way while you are offsetting gains that you're harvesting by setting up legacy positions.

So I think that's the key advantage of having the direct indexing portfolio as a target portfolio to transition to. If you compare that with what would happen if you were to transition to an actively managed equity portfolio where you only have let's say 40 or 50 holdings in some concentrated positions, you don't have that many opportunities to offset your gains by harvesting losses. So I think that's one key advantage. The breadth advantage that direct indexing provides while you're transitioning portfolios in a taxable fashion is a key one. So that's really the reason why I think direct indexing is a much better or an efficient tool for transitioning portfolios in kind.

Jenna Dagenhart:

Brandon, what are some examples of advisors using direct indexing to better manage their taxes and what's the best way to leverage the tax advantages?

Brandon Thomas:

Yeah. Jenna, it's a great question. There are many use cases we see from a tax management perspective, but I'll highlight a couple that many investors take advantage of with our strategies. And Kevin and Manju have talked about this already, and this is the most popular strategy on our platform is this transition strategy. A large number of clients will bring their legacy positions that they've had elsewhere. They may have acquired those either through inheritance or through ownership of a company's stock, but these positions typically have low cost basis. Often they're concentrated positions. They want to bring those into the portfolio and create a diversified portfolio into one of these direct index strategies over time. Kevin and mind you talked about that. And then they ask us to diversify around these positions in a tax efficient manner. As has been pointed out, it could be they want to immediately go into this diversified direct index strategy and incur whatever gains are embedded in the portfolio right now.

And of course that's high tax payment situation. Very low tracking error in that case, but high tax payment. On the other end of the spectrum, they may say, let's take five to seven years and work our way out of this position in a very tax efficient manner so that after that period of time we get into this fully diversified solution. But on a year by year basis, as the investor or the advisor, I'm able to manage the tax bill that I incur. So the transition strategy is extremely common. A second very common use case on the Envestnet platform, because we make full advantage of the unified managed account, which is a single custodial account with many managers participating as sleeves in that account.

In these cases, when the investor uses one of our direct index strategies as a sleeve in a unified managed account in an overall asset allocation and then applies tax management to the entire account, which usually consists of other SMAs, ETFs and mutual funds, tax management is done across the different accounts. So it's not just within that one direct index strategy, but it's across the different strategies that are in that account. It's a very powerful way to do it because our overlay team is able to manage taxes not only within our direct index strategy, but across all the other managers in the investor's account. And what this does is it allows for offsetting gains in one manager's sleeve with losses in another manager's sleeve to really effectively manage taxes. So it's one of the major benefits of a UMA structure and we see a lot of advisors and investors moving into that structure.

And then a third use case is very common as well where investors with SMAs will instruct us to harvest losses at particular times of the year, whether it's after a market dislocation, the market drops and some of their positions have now unrealized losses and they want to proactively instruct us to harvest those losses or perhaps they want to do it at year end to handle some of the tax situation that they've incurred earlier in the year. So a lot of different use cases, many different ways to take advantage of direct index strategies. And I'll just say this finally, that what makes the direct index strategy so popular and so effective from a tax management perspective is because of the number of holdings. I talked a little bit earlier about how that's sometimes a roadblock for investors seeing this high number of positions in their portfolio, but it really is effective from a tax management perspective because there are additional opportunities for losses, there are additional opportunities to offset gains with losses, and so it's just a much more effective way to manage for taxes.

Jenna Dagenhart:

Kevin, what should someone look for in a direct indexing provider and how do direct indexers differentiate themselves?

Kevin Maeda:

Yeah, that's a great question. There are a lot of new direct indexers coming into the marketplace so it is getting very crowded. It is getting harder to differentiate themselves because they largely are trying to pursue two main objectives, which are to maximize tax efficiency or tax alpha within a portfolio as well as to tracking index. And so I think the most important thing to look at between providers is really their process. The process is going to differ within the individual details. So for example, most of our other competitors that I'm aware of typically do use more stocks in the portfolios. They'll use say 200, 300 stocks or maybe more sometimes because they're trying to get broader diversification and focus more on tracking error. Within our portfolios, we actually do it very differently. We use more compact portfolios, typically about 150, and we focus on the tax management much more than on the tracking error. Tracking error is secondary for us.

And so as Brandon and Manju mentioned, if you have more stocks, you may think that you have more opportunities to tax loss harvest. I would actually argue that's not necessarily true because we've done this with 50 stocks, a hundred stocks, 150 stocks. We are actually very flexible and we'll use different numbers of stocks based on what client preferences are. And we found that if you're starting from cash portfolios, for example, whether you're using 50 stocks or 150 stocks actually has roughly the same amount of tax alpha. Now, this doesn't seem intuitive to people, but the reason why it works within the way we run portfolios is because ... I'll use a simple generic example. Let's say you're holding 100 different positions at 1% each versus holding 10 positions at 10% each. So you're holding portfolios at up to 100%.

You would think that in the portfolio that's holding 100 positions at 1% each, you'd have more positions that could potentially be loss harvested, and that's true by a number of stocks. But as a percent of the portfolio, maybe 10% of your portfolio is down, it doesn't matter whether you're spreading that out across 10 names or a single name. On average, what we found in our own experience running these for 20 years is that it doesn't matter how many stocks you're holding, the relative tax alpha as a percent of your assets is about the same. So that being said, then what's more important? Well, as some of my competitors mentioned, if you're holding more stocks that would bring down your typical tracking error. That's actually very true. And that tends to be more what they're focused on. What we tend to focus more on is the tax alpha.

So in cases where, let's say the market's down a lot, let's say you started a portfolio in January of 2020, market falls off in March, we're fully comfortable with liquidating the entire portfolio. Everything. And so that means we want to have enough available other stocks to select from to rebuild the portfolio. We're willing to take on higher tracking error risk in order to capture all the tax alpha in there. Most typically other competitors will use an optimization type of process that's different than ours where because it is focusing on tracking error or limiting the tracking error that they're allowed to have, they might limit the amount of tax loss harvesting they're doing at any given time as well. And that's the trade off you're doing. So instead of liquidating, say Apple, Amazon, Google, Facebook, they might sell some of it, but even if it were down 20, 30, 40%, they probably wouldn't liquidate everything.

And so this is one thing that we think investors should look at carefully and decide whether or not the tracking error is more important to them versus the tax alpha that they're trying to achieve because you're going to get a different experience based on that. One other thing I would point out related to the same thing is when you're transitioning portfolios of stocks or even concentrated stocks, is the provider willing to work with that compact portfolio and for how long? So for example, we're willing to take on a single concentrated stock and hold it indefinitely as much as they want to hold it, if that's their intention for tax purposes. We don't have a deadline that people need to transition out. It's up to them. And so if that takes their whole lifetime, that's fine. If they have a existing portfolio of 40 stocks, we won't liquidate most of that to get them to 250 for example.

If they still say that they don't want any net gains in their portfolio, that's fine. We'll keep it at 40. Maybe it goes to 50 or 60 over time, but maybe it stays that way. And for a lot of investors in the practical world, what we've found is they don't necessarily understand tracking our risk, but they do understand taxes. And even if we advise them as well, it's not a good idea to have concentrated portfolios. There's a lot of risk. At the end of the day, I don't know about you, but people just hate paying taxes. So a lot of times they want to be able to have control over that and say, "Look, I'm okay realizing $10,000 in gains this year, but I don't care what happens to the portfolio, I don't want to realize any more. Maybe next year we'll revisit this with our accountant. Maybe our situation will change where we have losses somewhere else and we could take more gains. I don't know."

But we really want to leave that up to the advisors and their clients because that's what we found a lot of them have their most serious concerns with is managing their tax aspect. So I'd say those are the major things that you'd notice. There's certainly a lot of other finite details in terms of how long people have been doing this type of activity. Do they have the experience? It is more complex than just running a single mutual fund or ETF because every account is different. So if you're managing thousands of accounts, every single account trades differently, every single one has different tax lots. That gets very complicated. And so the client servicing aspect relating to that as well can be very challenging where you want to make sure you have the knowledge and support throughout your organization so that they can in turn support the advisors and can provide them the education that they need and the support they need to then in turn explain that to their clients.

Manju Boraiah:

Kevin made a great point, so I just want to elaborate on that. The balancing the tracking your risk and the tax alpha, I think that's a key one. So as Kevin pointed out, FAs don't really understand the tracking error really well, but they actually understand tax alpha. But if you think about tracking error from a risk perspective, like a 1% tracking error versus a 2% or 3% tracking error and how that translates to performance differentials against the index, I think that's something that FAs should actually understand and study that more closely. Because if you have, let's say a portfolio that's tracking the index at 3% tracking error, you might be generating a ton of tax alpha, but the opportunity cost of not being able to track the index can actually ... So you'll end up paying in a different way so there's no free lunch in investing.

So I think that balancing the tracking error risk, which is generating more tax alpha, I think that's an interesting one that Kevin pointed out. So having different flavors of tax management where you have standard tax management where you are tracking the index really well, but more tightly and you're harvesting losses within that tracking lower bound, then you can enhance that tracking lower bound to 2% or 3% and harvest more losses. So the performance differentials by taking account tax alpha in those two different scenarios can be quite different in different regimes. Like in 2022, that's a great example where taking more tracking balance or tracking more broadly I would say, and then harvesting all the losses would've probably amounted to 4% or 5% of tax alpha in a typical S&P portfolio in 2022. And that probably was an exception. Going back 20 years, I think 2022 was a great year for you to take more tracking your risk and harvest all the losses, but that was just one year. So those regimes obviously don't repeat that often. So understanding the balance between tracking and tax alpha I think is a critical one for advisors to understand.

Brandon Thomas:

And Jenna, I'll just jump in there too. I agree with both Manju and Kevin. I think we've sort of gone the other way I think where we see a lot of advisors coming and using direct index strategies because of the under performance of active managers. So they're very concerned. They may not understand tracking error per se, but as Manju points out, they do understand under performance and tracking error really is a way of under performance manifestation. And so we want to make sure that the portfolios are tracking the index, that they're getting the asset class performance that they signed up for. And taxes are important. Sometimes it's secondary, sometimes it's most important. It depends on the advisor and the client. But I think the tracking error and the performance, the relative performance that the advisors and clients are looking for is really I think central to this whole direct index solution because many of these clients are coming from actively managed strategies that just have not done well.

The advisor doesn't want to have to explain under performance of active managers anymore. The clients are tired of having to endure under performance and paying exorbitant amounts for actively managed strategies. So they're coming and saying, "I want a direct index strategy that's going to give me the asset class performance at a very low cost and I'm going to get tax advantages as well." But I think in our perspective, I think that tracking your ... Or the benchmark awareness, I guess is maybe a better way to put it. The benchmark awareness of the strategy, the relative performance of the strategy is I think equally important at least as taxes.

Jenna Dagenhart:

Natalie, what would you say is most important to consider when choosing a direct indexing provider?

Natalie Miller:

I agree with Kevin and Manju and Brandon that understanding processes of the provider is important. Understanding their processes around tax management, around tax loss harvesting, around wash sale rules, around optimizations put in place to ensure that the risks of the portfolio stay in place, don't stray too far outside of what the client is expecting. Also understanding the processes around customization. What types of customization or personalization are offered? What kind of exposures does the provider have access to? I think it really comes down, as Kevin mentioned, it comes down to expertise and scale.

Are there service teams in place? Are those service teams able to deliver high quality and high level of customization that custom SMAs require? Do they have the experience of investing through multiple market cycles? Do they have the experience of working with $100,000 clients and a $100 million clients? Do they recommend truly custom portfolios or just model boilerplate portfolios? I think a provider also has to have a scalable and efficient investment platform to handle the growing number of individual accounts. That technology is super important to make sure that those individual portfolios, and they are all unique, are invested as they should be. In our experience, especially as you move up the high net worth scale, delivering an effective SMA platform is a mix of art and science. That technology is the science that provides the efficiency and the scale, and then the art comes from the human insight. A real live person to monitor and execute the trades, to interpret the results of those mathematical models, to provide insight and commentary and to act as a sounding board for the client. Act as a consultant to the client and the advisor.

Jenna Dagenhart:

Many people say these strategies are more for high net worth clients. Brandon, is this true or can all clients truly benefit from something like this? And what have you seen from working with advisors in the past?

Brandon Thomas:

Yeah. Historically I think, Jenna, because direct index strategies have required a larger number of positions, they've had higher account minimums. Typically around 250,000. I think that's been the account minimum that's been in place for most strategies going back in time. So for that reason, I think they've most often been associated with high net worth clients. However, account minimums have come down now quite a bit for a number of reasons. Kevin pointed this out. Our minimums are at $100,000 for our standard strategy. We go as low as 60 and sometimes 40 for some of our strategies. 40,000. You don't have as many positions, it's not as diversified, but you're still tracking an index. So the tracking error is a little bit higher, but account minimum has come down to 100,000 and maybe even lower, making these strategies accessible to a wider range of investors.

And so it's no longer only for high net worth investors. It used to be institutional, then high net worth. Now it's become much more ... I think maybe Manju pointed it out earlier. He used the term commoditized. And it's become much more accessible to all types of investors. In addition, as fractional share trading becomes more widespread, account minimums will come down even more opening strategies up to even more types of clients. And Kevin pointed this out. The tax management customization benefits of direct index strategies have also resulted in them being more aligned with the needs of high net worth clients historically. However we're able to now personalize these strategies. It's no longer just text management anymore is customization, it's true personalization where the client can create something completely unique from scratch that aligns with that investor's values, whatever it might be. It could be a combination of things. Factor tilts, ESG integration, any types of thematic investing. All those things can be combined into one strategy and that's beneficial to all types of investors. You've got younger investors that may not have a lot of investible assets that are very interested in some of those features. And so these types of direct index solutions and the personalization benefits they offer, I think are very beneficial to all types of investors now. Not just high net worth, but every type of investor that is looking for some long-term types of solutions.

Jenna Dagenhart:

Kevin, some providers are promoting direct indexing for very low minimums, even under 5,000. Is direct indexing appropriate for the masses?

Kevin Maeda:

Yeah. I'm a little bit skeptical on that. And at least with the clients that we work with, the majority of them, the number one thing that they're looking for is the tax management or tax enhancement that you could get beyond an ETF or an index mutual fund. And that honestly only really makes sense at the higher tax brackets. So let me give you an example. Let's say you have a $5,000 portfolio, you're in a lower tax bracket, presumably. Maybe you can realize $100 in tax losses last year, and that would actually be quite a bit for 5,000 portfolio. So you have a $100 loss, maybe you're at a 12% tax bracket, you're talking about a $12 federal tax benefit if you can offset that with a short term gain. Is it worth it for $12? I don't know. Maybe, maybe not.

But again, for most people who are using this for tax reasons, I think for the mass market, this probably is just not worth the extra effort. However, again, for the personalization and customization, maybe it is because it can be very difficult to get those custom portfolios. I think over time we do have more and more ETFs and mutual funds that can slice the market in different fashions. Maybe those are good enough, but for an individual who wants say a portfolio to exclude a specific sector, three specific stocks and have a couple of ESG screens on top, you can't buy that off the shelf anyways. So if they really wanted to do that, they could. And again, for some people that might be worth it. I think for the broader mass market though, I'm still quite skeptical on whether that will really work and take off.

Jenna Dagenhart:

Manju, how is direct indexing helping to solve problems for retail investors?

Manju Boraiah:

As Kevin and Brandon pointed out, Jenna, I think there are three themes that we've been talking about. The concept of personalization and customization, tax management and tax away transitions. So if you take those three broad themes and apply to the wealth spectrum anywhere from mass affluent all the way to ultra high net worth, the benefits as we've talked about earlier for people in different parts of the wealth spectrum is going to be different. So in the ultra high net worth space, tax management probably is the primary key benefit there. Maybe obviously customization will play a role, but generating that additional tax is the primary goal. But if you come down the wealth spectrum to mass affluent, maybe it's the customization that actually takes the lead and not the tax management.

Because at $50,000, as Kevin pointed out, you can buy an ETF if you want to get exposure to index, but you can't customize it. You can't throw out a sector or certain stocks in the index. So the ability to customize and pull the customized portfolio at that lower minimum, I think you can only do it through direct indexing. So I think the benefits to different investors in different parts of the wealth spectrum is going to be different and it's going to vary through time. And so to me, I think that's a key benefit. The other piece is being able to structure your portfolio to write different parts of the regime changes, and as you go through non policy changes or growth changes or inflation regime changes, to me, I think that's another key aspect. You really can't do that in an ETF or a mutual plan.

So having access to a tool like direct indexing and using the way these indices to actually either blend indices, customize those indices and kind of structure a portfolio in a certain way, you can only do that through direct indexing. And then the last part is I think we've talked about diversification as a team here. The ability to diversify out of a concentrated position, be it single stock position or a mutual fund. I think that's again, very hard to do if you're doing it through an active strategy, but it's much more easier and then you have more options to customize if you do it through direct indexing strategy. So those are the key benefits that directing indexing offers to retail investors.

Jenna Dagenhart:

Natalie, I would love to hear your thoughts as well on which investors benefit from direct indexing.

Natalie Miller:

We've certainly talked a lot on this call about the improved tax efficiency that you get from direct indexing. Certainly managing tax losses and gains throughout the year at an individual security level is one of the most talked about features of direct indexing. And so a client who requires tax losses to offset gains elsewhere in their portfolio, we certainly find direct indexing especially valuable, but tax loss harvesting is far from the only value of direct indexing and we've mentioned some of those. So if you think about creating a client specific environmental social governance or ESG guidelines, direct indexing works exceedingly well when it comes to tailoring portfolios to reflect a client's unique ESG principles and advisors can make this happen using a variety of methods from screening out objectionable industries to filing shareholder resolutions. So direct indexing gives those advisors and investors more control over the securities they hold. More control than they would get through an ETF or a mutual fund.

I think diversifying around or out of concentrated positions, Manju mentioned that. Direct indexing helps clients manage and unwind those overweights through tax lost harvesting, through planned charitable giving, tax efficient withdrawal techniques and having the tools to solve those complex client problems is a really great way for advisors to attract more business and deepen their existing relationships. I think the last potential client type is someone who wants to do tax efficient charitable donations. So donating highly appreciated securities to charity means that that investor avoids the tax liability of the gains embedded in the security.

Jenna Dagenhart:

Kevin, how does direct indexing work with concentrated stock?

Kevin Maeda:

We do have situations where clients have a concentrated stock. Maybe they're executives at the firm or exercise stock options or something like that. And oftentimes they're somewhat paralyzed. They don't want to sell off the stock, realize large gain, again, pay their taxes. So we typically work with them in a couple different ways. One is that first of all, we will take concentrated stock into portfolio even if it starts off at 100% of the account, but we do recommend that they allow us to at least start transitioning the portfolio. And there's two different ways we typically do that. One would be to transition that over a finite time period. They're free to choose how long that is. It could be a year, it could be 10 years, a hundred years. Doesn't really matter. They could also change that over time. But essentially we're going to be dollar cost averaging out of that concentrated stock position and then diversify that into the rest of the index.

The other way would be to fund the account with some cash in addition to the concentrated stock, build a portfolio around that concentrated stock and then to diversify them over time with a capital gains budget. And in many cases, again, the clients might say, "I don't want any net capital gains. Only chip away at my concentrated stock." If you could realize losses in other parts of the portfolio, that's fine. It might take a very long time, it might not even fully ever transition. But what they can do is they can observe the portfolio and see how it's working over time. Maybe you do hit a market like 2022 and you transition a lot more or a lot more quickly than you anticipated and then you're back into a bull market and maybe you're not transitioning very much anymore. And so at that time they have a couple of options where they can gift or donate the stock away. They can perhaps add more cash in the portfolio, reset some of the basis, restart the loss harvesting going again, or perhaps allow us to realize net gains on that concentrated stock to chip it down to then diversify the portfolio over time. So there's a lot of different ways that we'll work with them and they have the flexibility to change those over time as well.

Jenna Dagenhart:

What about fixed income strategies? Brandon, do you consider them to be part of direct indexing?

Brandon Thomas:

Yes, absolutely. We believe that any type of strategy that can be quantitatively constructed and systematically managed should be considered within the realm of direct indexing or what's called direct indexing. And that includes fixed income. In our mind, strategies don't necessarily need to explicitly track an index to be considered a direct index strategy. I should also say that I've never been a fan of the term direct indexing when it popped up three or four years ago. It's more of a strategy. These types of solutions have been around for ... In the retail space, high net worth retail space, they've been around for 25 years or more. In the institutional space, they've been around for 40 plus years. And so this term direct indexing really just popped up in the last three or four years. I've never really been a fan of it, but it is what it is.

There's this implication that strategies are necessarily tied to an index when you talk about direct indexing, and that's not the case. What these strategies are, whether they're equities or fixed income, they're really quantitatively constructed, systematically managed strategies, whether or not they're explicitly tied to an index. Now, direct indexing has historically been associated, for example, with us large cap core equity index strategies. S&P 500, Russell 1000. That's the bread and butter for most of the managers on this call. And there's no reason that all other asset classes and styles, equity asset classes and styles, growth value should not be included, including fixed income, as part of the directing indexing family. We launched a series of corporate municipal and treasury bond ladders about a year ago, and they've been tremendously successful. From a percentage growth perspective, they've been our most successful strategy over that period of time. The interest rate environment has a lot to do with that, but just the fact that investors and advisors have an alternative now that's systematically managed, they know what they're getting. It's very low cost. These types of strategies we believe are also direct index strategies.

Jenna Dagenhart:

Turning to you Manju, what role does direct indexing play in fixed income?

Manju Boraiah:

Yeah, I agree with Brandon, Jenna. I'm not a huge fan of direct indexing terminology as well. I mean we prefer to call it custom SMAs just because the concept of being able to customize and tax manage portfolios in an SMA vehicle is broadly applicable to equities and fixed income. So when we entered the custom SMA space a few years back, we decided to actually do it in fixed income. So similar to Brandon, we actually started with munis, IG corporates and treasury ladders and the capability to customize these lateral portfolios across a few dimensions. So obviously credit quality is a key metric in fixed income. Maturity of duration is another one. And then with munis, you can also do it geographically. It could be a national portfolio or a state specific portfolio or state preference portfolios and being able to blend these different kind of metrics and create a portfolio that actually fits the need for advisors and their clients.

So I think fixed income plays a huge role in our view and one of the unique approaches that we are taking in fixed income, especially if you think about corporates and munis, the credit risk actually plays a huge role. So we think about blending fundamental research and systematic portfolio construction to build these portfolios. So we leverage our fundamental research recommendations to be able to do credit selection or security selection because in the fixed income world, especially munis, you have a million [inaudible] that are outstanding. And if you look at the broadest index, which has about 60,000 muni bonds, to go from 60,000 bonds or maybe more to selecting 20 or 30 bonds from a few issuers, you can't necessarily rely on your systematic goals because the key part in fixed income for generating returns is to manage that credit trust.

So we rely on fundamental research and we blend that with our systematic portfolio construction capability to essentially go from a few thousand bonds down to a few hundred bonds and then rely on fundamental research to pick the best bonds to create the ladder portfolio. So we do that in munis, we do that in corporates. Obviously treasuries, there's no credit risk so it's a matter of picking the right bonds to create the right duration profile and maturity profile. So I think it plays a huge role in fixed income. When you put the two together, direct indexing and equities and ladder portfolios and fixed income, you can essentially build a multi-asset custom portfolio in a much more scalable fashion. So that's the key advantage.

Jenna Dagenhart:

What about a multi-asset approach, Natalie? What does a multi-asset approach to direct indexing look like?

Natalie Miller:

Often it looks like a core satellite approach. So a passive core surrounded by more active satellites. And if direct indexing is used as the core with tax loss harvesting, those losses can offset taxable gains that the more active satellite managers may generate. So like Brandon mentioned, while direct indexing has typically been large cap US equities, it can also include broader beta exposure like small cap and international. And as we've been talking about, it can include fixed income through laddered munis or corporates. And as we've said in this case, rather than an index benchmark, clients can choose their desired maturity credit quality geographic characteristics. We've found that that core satellite structure offers the potential to greatly increase after tax returns across the whole portfolio. So using direct indexing in a portfolio's core can also reduce overall portfolio management fees, trading costs, and active risk levels.

Benefits of this model extend to the advisor as well. In an all active portfolio, the advisor is responsible for ongoing due diligence of each manager. By allocating the core to a more static long-term allocation, the advisor can focus their diligence on just the satellite managers with the most potential for out performance. That frees them up to manage wealth more holistically through retirement planning, estate management, charitable giving, strengthening those existing client relationships and creating openings for new ones. There can also be a risk management as well. Our research found that a core satellite approach results in portfolios with better downside protection in after-tax returns. So even when the active satellites underperformed the tax loss harvesting in the core softened that under performance on an after-tax basis. So there's that risk management benefit as well.

Jenna Dagenhart:

Well, I'm sure all the advisors and financial professionals watching today learned a lot about direct indexing, and I wish we had time for more, but we better leave it there. Everyone, thank you very much for being with us.

Kevin Maeda:

Thank you very much.

Brandon Thomas:

Thank you, Jenna. Thanks everybody.

Jenna Dagenhart:

And thank you to everyone watching this direct indexing masterclass. Once again, I was joined by Brandon Thomas, co-founder and co-CIO at in Envestnet, Kevin Maeda, CIO of Direct Indexing Strategies at Natixis Investment Managers, Manju Boraiah, Head of Custom SMA Investments at Allspring Global Investments, and Natalie Miller, Director of Investment Strategy at Parametric. And I'm Jenna Dagenhart with Asset TV.