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Should You Follow Vanguard Into Direct Indexing?

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. In mid-July, Vanguard made its first-ever acquisition, buying direct-indexing firm Just Invest. Here today to talk about what the benefits and drawbacks are of direct indexing, as well as discuss the future of direct indexing, is Ben Johnson. Ben is Morningstar's director of global ETF research.

Hi, Ben, thank you for joining us today.

Ben Johnson: Hi, Susan. Thanks for having me.

Dziubinski: Let's start off with talking a little bit about what direct indexing is? And who's doing it.

Johnson: It's a great question. And for anybody who can remember the old Mike Myers sketch from Saturday Night Live, Coffee Talk, where he played a character named Linda Richman, direct indexing is neither direct nor indexing, I would argue--so let's discuss. Why direct indexing is really called direct indexing is that it is a capability, it's a way of building a portfolio that meets very specific needs of individual investors that more often than not starts with an index. So, it might start with a total U.S. stock market index, for example. And then it takes into account a variety of circumstances, a variety of preferences that are unique to that specific individual, as it pertains to their tax situation, as it pertains to their preferences under the umbrella of ESG, as it pertains to their desire to achieve maybe better-than-market outcomes by betting on different factors like value and/or momentum.

From that starting point, what a direct-index strategy does is it tailors that index to meet those specific needs, to understand those specific circumstances, to try to optimize for things like taxes or ESG preferences or factor exposures. So, where that lands an investor is in something that looks very different from the starting point, from that broad-based market-cap-weighted index, but has been cut to fit their preferences and is ultimately going to take the shape of a separately managed account. And how they get from that starting point to that tailored portfolio is increasingly some sort of software application that brings to bear all of the data around taxes and tax preferences and tax lots, ESG criteria, factor exposures, you name it, and takes data from the end investor to arrive at that outcome, which is a customized portfolio designed to meet the specific needs of that investor.

Dziubinski: What are the benefits then of these customized portfolios?

Johnson: Well, most of the investors, I should stress, that have used direct indexing historically tend to be high-net-worth and ultra-high-net-worth individuals. So, the minimum sort of entry point for a lot of these portfolios is somewhere between $250,000 or $500,000, no different than traditional separate accounts. And what you see is that oftentimes, they come to sit across the table from their advisor or an asset manager with an existing portfolio of securities or maybe even a portfolio that has a very large concentration in say their employer's security if they work for a publicly traded firm. And what they want to do is to avoid liquidating those securities and build a portfolio around them, so that they avoid unlocking any tax costs, any taxable gains that they may have in the portfolio that they come to the table with.

On an ongoing basis direct indexing also allows for security by security tax-loss harvesting. Those tax gains, that tax alpha potential of direct indexing has really for a long time been one of its primary points of appeal. Now, at the margin, what becomes more appealing to a larger number of investors is mass customization. As I said before, the ability to build a portfolio that meets your very specific ESG needs, your very specific ESG criteria on a stock-by-stock level, as opposed to maybe buying an individual ESG mutual fund or ETF off the shelf that's designed to meet the preferences of a broad base of investors but might not meet your specific preferences. So, mass customization, the ability to design a portfolio that meets your specific needs, that's, I think, the broader appeal and will be for some time of direct indexing.

Dziubinski: Let's look at the flip side, Ben. What are some of the drawbacks of direct indexing?

Johnson: Well, I think there are a number of drawbacks. Even if you look at the primary benefits of direct indexing, and I mentioned before a lot of that has to do with trying to generate tax alpha, to regularly create realized losses to offset gains, to build a portfolio around an existing portfolio that may have big embedded gains. At some point that portfolio becomes what is called locked-up, that all the securities in that portfolio are in gains, and there are no more losses to realize. So, the shelf life of that particular feature may be limited, depending on what's in the prevailing market, there might not be opportunities to realize those losses and generate that tax alpha, if you will.

One of the other detriments is that it's incrementally more costly than building, say, a portfolio of broadly diversified ETFs. There are fees involved, and those fees tend to be in many cases a multiple of what you would pay for a broad-based portfolio of low-cost active funds, ETFs, or mutual funds, you name it. The other element is that it's more difficult to measure some of the costs that you can't see, in direct indexing the costs involved in regularly turning over that portfolio. There are frictional costs that need to be accounted for as well. And then the last cost, and what I would argue might be the most important one, is the potential opportunity cost of direct indexing. And what I mean by that is that, for all intents and purposes, direct indexing allows individual advisors or the investors themselves to basically become a discretionary stock-picker. The preferences that they input into this model are going to yield a portfolio that's different from the broad market, from a broad-based index fund. And that may, over a long period of time, result in better risk-adjusted returns than they might have gotten from a broadly diversified portfolio of index funds. It might result in worse returns.

Looking forward into the future, you just don't know on day one. But nonetheless, it makes a large number of investors effectively active managers. And what we know about active management, about being different from the market really in any way, is that sometimes it's going to look right and feel good, and sometimes it's going to look wrong and feel bad. That goodness or badness could be an opportunity cost to investors. There could be circumstances where they would have been better served, they would have gotten greater returns with less risk by simply just owning a portfolio of broad-based index mutual funds or discretionary active funds.

Dziubinski: And then lastly Ben, several other asset managers, including BlackRock and J.P. Morgan, have also purchased direct-indexing firms. How widespread do you think direct indexing is going to become over time?

Johnson: Well, I think it's going to become more commonplace over time. And I think what you've seen with the raft of acquisitions that we've seen just over the course of the past year-plus, is that the asset managers are jockeying for position. They want to offer greater breadth of choice to meet the diverse needs of a diverse investor base. They have clients that come to them with any number of different unique circumstances. And this isn't going to necessarily be your silver bullet, it's not going to be a solution that is going to meet the needs for all investors. I think it could very well continue to meet the needs of some. Now that said, what I expect to see is that there will be efforts made to bring direct indexing to smaller investors over time. As I mentioned before, historically this has really been the reserve of high-net-worth and ultra-high-net-worth individuals.

What you see in moves that have been made in recent time by the likes of Charles Schwab, for example, moving toward zeroing out stock trade commissions, moving toward offering fractional share trading, so I don't have to buy a whole share of Amazon, I can buy a slice of a share of Amazon. I really see that as the necessary groundwork to open up direct indexing to a more mass-affluent audience, to a broader number of investors. And indeed, sticking with Schwab's case for now, they acquired the legacy assets of Motif, which was an upstart that really was looking to do exactly this, to make something that looks like direct indexing available to a broader spectrum of individual investors. So I think directionally, that's where we're going to see more and more firms headed in the coming years is toward widening out this capability to a larger audience of their investors.

Dziubinski: Well, this is really fascinating. Looks like we could be you know, at the start of something that could turn out to be pretty big thing for investors of all types. Thank you for your time today, Ben, we appreciate it.

Johnson: Thanks for having me, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.

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