Direct indexing will finally enjoy wider engagement and use in 2023, but it’s not yet ready to come down market to the bulk of the wealth management industry, according to Anton Honikman, CEO of MyVest.
“I’m not necessarily of the view that 2023 will be the year that direct indexing becomes broadly democratized,” said Honikman. “There’s a different discussion about bringing direct indexing to a broader market. What’s hindering that is the need for more of an experience with direct indexing.”
MyVest is a wealthtech subsidiary of TIAA offering a wealth management platform built around portfolio management, trading, rebalancing and reporting capabilities.
The necessary building blocks for effective direct indexing are in place across the wealth management industry, said Honikman: access to fractional shares, commission-free trading and portfolio management technology capable of handling the nuances of direct indexing.
In direct indexing, a portfolio holds all of the underlying components of an index—the about 500 stocks that make up the S&P 500, for example—rather than a mutual fund or ETF that tracks the S&P 500. By owning the individual components of an index, customized investment decisions can be made to concentrate on or avoid certain investments or types of investments and more efficient portfolio tax management is made possible through the trading of individual positions.
“I’m a fan of direct indexing,” said Honikman. “I think it will continue to grow, and I think it’s emblematic of an inexorable trend towards more personalized solutions. It’s also emblematic of the real interest and desire for more tax management., particularly among the affluent and high-net-worth investors. For those reasons, I’m really positive about its future.”
Not There Yet
But 2023 will not be the year direct indexing becomes ubiquitous in wealth management because the technology to unlock its full potential is not in place, said Honikman. Such technology would enable the true personalization of financial plans and portfolios at scale—in its absence, it makes more economic sense for firms to serve down-market clients with the next best alternative: low-cost, tax-efficient, ETF-based portfolios.
Instead, 2023 will be a year that technologists and wealth management firms continue to invest in solving the personalization problem, said Honikman, by focusing on building the on-boarding experience and the data collection, management and reporting capabilities that will eventually enable direct indexing.
“Critical experiences are holding back the democratization of direct indexing,” he said. “If you don’t think of direct indexing as a product and think of it as some sort of solution wrapped in an experience, what are the deficiencies in those experiences that need to be invested in? Examples would include profiling and preference capture at scale. To really do direct indexing, you have to go beyond the traditional risk-profile questionnaire and steer more towards values, needs, goals and tax profiles, things like tax returns, tax budgets, carry forward and the like.”
A new category of technology is oriented towards more robust data collection and a better-rounded client discovery experience, according to Honikman: advice engagement. Technology in the advice engagement category, which recently made its debut on Michael Kitces’ Financial Advisor Fintech Solutions Map, includes software like FP Alpha, AssetMap, Elements and Bento Engine, designed to improve the way advisors and clients interact around plans, investments and other topics.
Improved data collection and storage across the industry will not only help power personalized investment solutions like direct indexing, it will also pave the way for artificial intelligence to be implemented in a more holistic manner among wealth management firms.
Reporting capabilities at more firms need to move beyond multiple-page statements with one-line entries for security-level holdings that merely report financial performance against a benchmark, said Honikman, and come to address more of the tax-efficiency, impact and social responsibility goals that investors bring into the advisory relationship.
Personalization
“What’s driving change is big demographic shifts and the ubiquity of information, Moore’s law and the continued reduction in the cost of technology, and the continued advancements in digital technology,” said Honikman. “Where that’s heading is not just personalized investment solutions of which direct indexing is an example, but personalized experiences at wealth management firms.”
Thus, direct indexing is a symptom of the movement towards personalized experiences, and not just a novel mode of investing, said Honikman.
An increased focus on tax efficiency is also gradually pushing the greater wealth management industry towards direct indexing, he said.
“Instead of tinkering around with one asset allocation or another, the net value-add that can be more deterministic for client outcomes is tax managing, so we’re now seeing it everywhere,” said Honikman. “It’s become a field—technology is now helping to manage tax-aware transitions, overlays, it’s working within direct indexing, and it’s also being applied in the field of tax-smart retirement withdrawals across a household’s multiple accounts.”
Technology should help bring better tax management to more people in 2023, he said.
Alternatives
More alternative investment strategies will likely be developed and used in 2023, but not necessarily the alternatives advisors have become most comfortable with.
While technology is making some private-market opportunities available to more investors, Honikman thinks more outcome-oriented structured products will come into portfolios over the next year.
“I like the technology firms focused on structuring investment solutions for certain objectives or outcomes, like tail-risk management or retirement income, using structured products and insurance products to alter outcomes,” said Honikman. “This is really an exciting frontier for alternatives, broadly defined, beyond the classic alternatives. Some of these innovations will end up being better for someone than just a 60/40 portfolio.”