Consider the mix tape.
Decades ago, it was the most technologically advanced way to share a batch of music. A lineup of songs specially curated by the right person could say “I love you” or bring back memories of a shared experience.
Then the technology advanced. Now, with a few clicks, we can make our own electronic mixes any day and for any occasion — or allow cloud-based virtual assistants to surprise us.
Now consider the mutual fund.
Decades ago, it was one of the most common ways to invest. For a smallish fee, an ordinary investor could buy into a portfolio of stocks or bonds specially curated by a financial expert. But just as with music, movies, cars, pharmaceuticals, robotics, money and so many other products, investing has evolved.
An innovation often called “direct indexing” is gaining ground with affluent investors, and is likely to soon start to reach the retail masses. If mutual funds were mix tapes and exchange-traded funds were like the deejay machines that made an appearance in mall record stores for a few years, direct indexing is Spotify /zigman2/quotes/207488629/composite SPOT -0.02% or Pandora: personal, technological, disruptive, and even a little sexy.
The idea is simple, and it isn’t new. Big institutional investors like pension funds have long used customized indexes that reflected certain priorities for their portfolios. Rather than investing in the entire S&P 500 /zigman2/quotes/210599714/realtime SPX +0.81% , they’ll select for large-cap stocks with a value tilt, leaving out tobacco companies, for example.
“All that’s changed over time is the thresholds for accessing an index have gotten lower and lower,” said Dave Nadig, an index industry veteran now serving as chief investment officer and director of research at ETF Database. “It’s just a software problem. And the technology required to produce that customized account has plummeted to the point where it’s almost retail. It’s not quite mom-and-pop, but it’s heading there.”
One of the many companies trying to solve the “software problem” is O’Shaughnessy Asset Management. Canvas, O’Shaughnessy’s direct indexing product, is shared with a select few registered investment advisors who can offer it as a service to their clients.
For that client, access to Canvas means that rather than holding a bunch of individual securities that may or may not mesh well together, or being at the whim of fund creators who select the securities inside their funds according to their own beliefs, he can create a customized index that makes sense for him, in very specific ways.
That could mean starting with the S&P 500, then stripping out the two companies where a husband and wife work and already hold big chunks of the firms’ equity. It may be a broad index of stocks less fossil fuels, or private prisons, or other companies whose missions or practices offend particular sensibilities.
Those features were familiar to Canvas’ creators, but Patrick O’Shaughnessy, the company’s CEO, told MarketWatch that one of the biggest surprises from seeing the program in action — it’s been in service since November — had to do with investors’ taxes. “We didn’t anticipate how much effort we would spend customizing tax profiles, setting limits on the capital gains tax a client might be willing to pay,” O’Shaughnessy said.
“Setting limits” may be putting it mildly. Direct indexing’s secret sauce may be just as much about actively managing tax-loss harvesting for clients as it is about keeping portfolios ESG-friendly. That means that a program like Canvas will watch for stocks that are losing value, and sell them in order to offset capital gains on others that have gained.
For many observers, the problems direct indexing aims to solve may sound like nice ones to have. It’s a uniquely first-world complaint to inherit a substantial stash of the stock of a Fortune 500 company, say, or to have the resources to devote to actively strategizing how to avoid capital gains taxes.
But industry participants say direct indexing is just another innovation that starts with early adopters and diffuses its way outward.