A couple years ago, I googled direct indexing and there were 5.6 million results. Today, 150 million. I knew I should have copyrighted that one.
Direct indexing, or personalized investing, touts two major benefits for investors. The first being tax optimization and transition and the second personalization, where someone can align their respective portfolio to their values. For now, let’s focus on personalization.
Recently, I wrote an article on personalized investing and how this trend may be coming faster than you think. I still believe that to be true but we still have a ways to go. Let me explain.
Aligning portfolios and preferences
A few weeks ago, I was on a call with a firm discussing direct indexing. The conversation was focused on how the platform could tax manage and personalize a client’s large-cap portion of their taxable portfolio.
Sectors, industries, and individual stocks could all be excluded. Portfolios could screen out companies based on their involvement in certain activities, like civilian firearm manufacturing or operating for-profit prisons.
Clients could even implement factor tilts to try and invest like some of the world’s most famous, and successful, investors.
This firm described how portfolios could truly be aligned with a client’s preferences, and when they spoke about average tax alpha north of 100 basis points they had me at ‘hello.’
However, I was concerned there was no focus on the client’s entire portfolio. What about personalizing and tax managing the rest of the portfolio?
How would small- and mid-cap exposure be managed and accounted for? What about international exposure? What if an investor’s portfolio is not all in one centralized place?
It’s not uncommon for a client to have a 401k or two, IRA accounts, UTMAs, and 529 plans. How are all these accounts, and the stocks held within each, going to be managed in one cohesive fashion that incorporates investor preferences?
Know your client
One of the tenets of Regulation Best Interest (RegBI) is ‘Know Your Client.’
If a client tells her advisor she has some ESG preferences, such as “I don’t want to own tobacco stocks”, is the advisor obligated to let the client know she owns that stock in her 401k plan, IRA accounts, UTMAs, or 529 plan?
And further, let the client know if there is a way to take action or not.
Yes, I’m sure there are folks reading this thinking I don’t understand the legal rules to fiduciary standards nor how the qualified space works under the Department of Labor.
Imagine you find out there are termites in your house, so a company comes by to inspect and gives you a quote to solve the problem. However, when you look further, you realize the quote didn’t cover termite removal in bedrooms or bathrooms. Are you serious?
There is hope, however. Account aggregation services exist that help bring all of an investor’s accounts into one place.
Some are even getting pretty good at displaying investment risk and exposure. When you combine this with portfolio construction and rebalancing tools you can begin to see a future where risk is managed seamlessly across every portfolio an investor owns.
Each unique exposure is accounted for and managed as part of a cohesive whole. Preferences are layered in and investors can see what they hold and where, and how that aligns with their values.
And perhaps most importantly, the entire program is managed with taxes in mind.
What do investors want?
McKinsey put out a survey in late 2021 that found that greater than 70% of consumers expect personalization, and even more, roughly 76% of consumers, get frustrated when they don’t find it.
Personalization is the new normal and is here to stay. And it is only natural that the demand for personalization is finding its way into investor’s portfolios, but we’re just not there yet.
While the industry is making tremendous progress, and I continue to remain optimistic on the future of the holistic investor experience, we still have a ways to go.
Peter Dietrich is head of wealth for Morningstar Indexes.