Direct Indexing: The Next Big Thing?

There are times in the asset and wealth management industry when you can see the future begin to unfold. Consider the evolution in how financial advisors meet the needs of their clients: The past 10–20 years have seen the emergence of fee-for-advice pricing models, the resurgence of trust services that optimize the transfer in wealth from baby boomers to younger generations, and the explosive growth of ETFs. Now set beside them a relative newcomer in direct indexing and ask: Are custom index solutions the next big thing?

Lorraine Wang?certainly thinks so.?

Lorraine is the MIT-educated founder, President and CEO of?GAMMA Investing, a San Mateo-based startup asset management firm offering investors personalized index investments strategies through separately managed accounts.?

I recently sat down with Lorraine to ask her why she left a 30+ year career at established financial firms like JP Morgan Chase, Morgan Stanley, the New York Stock Exchange, PowerShares and Invesco to brave the challenges and opportunities of starting an investment advisory business.

JT:?A recent report by Cerulli Associates?projects that direct indexing is poised to grow at a faster rate than ETFs, mutual funds and separately managed accounts over the next five years. Do you agree with that assessment?

LW: I absolutely do. I believe direct indexing may play a significant role in the future of asset management. It’s just getting started in terms of usage and adoption. Even though direct indexing had been made available to investors since the 1990s, we are still in the very early innings of its growth.

I spent two decades in the ETF industry, mostly working at PowerShares. I’ve seen the growth of ETFs. I believe direct indexing is going to take a similar trajectory. Where we are today reminds me of the ETF industry in year 2000, when ETF assets under management were only $500 billion. When I talked to advisors back then and asked them, “Do you use ETFs?” they would respond, “No, I don’t use them” or even “What are they?” That’s where I see direct indexing is now.

JT: What will drive the growth you believe we are going to see in direct indexing?

LW: Several things. First, direct indexing helps advisors provide something that differentiates them from what others are doing.?

In addition, investors are increasingly incorporating passive investing strategies in their portfolios, and direct indexing is benefiting from that. Direct investing enables broad-based exposure to the market while still providing some degree of customization, and often for a lower fee than what you’d pay with active management. In certain market environments it can be an incredibly useful strategy.

Finally, there are taxes. Mutual funds and active equity separately managed accounts are “serial capital gains distributors,” and taxes can wipe out much of the returns these products can generate.

Of these features, by far the most compelling is the tax impact – the ability to generate losses through selling to offset gains and then, as the portfolio is being rebalanced, to defer gains. While most investors are focused on alpha and chase excess return, they can pay more in taxes than they need to because other investment strategies can generate taxable gains. Direct indexing can help minimize that tax liability.

JT: Forgive me for asking, but how is that different from what advisors have been doing for decades?

LW: Previous versions of tax loss harvesting were 1 to 1: If an investor’s Apple holdings had a loss, an advisor could sell Apple to harvest the loss, replace it with something similar and then buy Apple back a month later. Advisors would often execute this 1:1 approach only once a year, typically toward end of the year. Compare that to direct indexing, which uses optimization software to opportunistically harvest losses across a portfolio of many stocks all at once and all the time. Continuously.

As an example, so far this year, most U.S. large-cap indexes were up nearly 17% through the first half of the year, but because of how narrow the market’s been, more than half of the stocks in those indexes were down during the same time span. Using the continuous harvesting capabilities of direct indexing across a portfolio of at least 300 stocks, our data shows that an investor would have been able to harvest at least 5% in losses through the year. That’s not something individual advisors were able to do in a scalable way. Now, thanks to technology, they are able to offer it en masse and at scale through direct indexing.

JT: A Morningstar white paper titled?Sizing Up the Potential Tax Benefits of Direct Indexing?studied the performance of a hypothetical tax-loss harvesting strategy applied to a broad market index. It found that direct investing generated a tax alpha of 1.04% over the period of January 1999 to March 2022. Does that seem about right to you??

LW: Yes, that is what our historical back-tested analysis shows as well. For a portfolio of U.S. large cap stocks, tax alpha can range between 1% to 2% annualized. For a portfolio of smaller cap stocks, tax alpha can be higher than 2%.?

JT: It's interesting you emphasize the tax benefits of direct indexing because most people would associate what GAMMA does with customizing an index – adding or subtracting individual securities based on an individual's values or their exposure to particular sector through the company they work for. Is customization an attractive feature?

LW: We’re finding that while customization is a differentiating feature, it’s not as much as taxes. Also: What kind of customization are we talking about? Most people see it as excluding stocks or industries or applying an ESG screen. We don’t see a lot of that. What we do see is advisors liking the ability and flexibility we afford them to offer a broad range of investment strategies to their clients – the ability to offer diversified exposure across asset classes through a customized comprehensive investment strategy.

JT: What's the biggest challenge facing GAMMA and direct indexing in general?

LW: It’s still a new concept to many advisors. They see the benefits, but they’re not sure. It’s all about education – case studies and one-on-ones showing advisors how to use it.?Some are opening accounts for themselves to see how it works before going out to clients. We’re spending a lot of time on education.

JT: GAMMA is one of the few independent direct indexing providers?– and the only one that's woman-owned and -led. Are those advantages?

LW: It’s true, there’s been a lot of consolidation in the industry because many people see the benefits of direct investing and are betting on its future. Parametric was acquired by Morgan Stanley. Aperio by Blackrock. Just Invest by Vanguard. O’Shaughnessy by Franklin. 55iP by JP Morgan. We ourselves have great, supportive capital partners in Riverfront Investment Group and Baird. As far as being woman-owned and -led, it’s not a factor: You need to prove yourself.?

JT: Thank you, Lorraine.

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Lorraine Wang is the President and CEO of GAMMA Investing LLC ("GAMMA"), a registered investment adviser with the state of California. Baird Financial Corporation and RiverFront Investment Group LLC have acquired minority ownership interests in GAMMA Investing LLC. GAMMA is operationally independent of RiverFront and Baird.

Discussions of tax alpha or efficiencies are hypothetical and do not represent the long-term results of an actual investment. No representation is being made that any portfolio will achieve tax alpha that Morningstar's research described. The effect of taxes on an investment should be a consideration when making in an investment decision within a taxable (i.e. a non-qualified) account but should not be the sole determinant. With respect to the description of investment strategies or investment recommendations described herein, there are no assurances that they will perform as designed. Past performance is not indicative of future results. Every investment program has the potential for loss as well as gain.?

Investors should consider the investment objectives, risks, charges and expenses of an exchange-traded fund carefully before investing. This and other information can be found in the prospectus or summary prospectus. A prospectus or summary prospectus may be obtained by contacting your Baird Financial Advisor. Please read the prospectus or summary prospectus carefully before investing. A direct investment cannot be made in an index.?