“Tesla /zigman2/quotes/203558040/composite TSLA -4.86% started with the Roadster, and then came the Model X, Model S, and Model 3,” O’Shaughnessy said. “The best way to perfect a technology is to attack the hardest use case first. Our customers tend to be very wealthy, ultra-high-net-worth individuals with peculiar tax settings or circumstances: complicated financial lives. Our marginal costs are high enough that we couldn’t do this today for retail investors, but all of these direct solutions will keep pushing down market.”
One early sign of that push downstream is a “stock-level tax-loss harvesting” service offered by robo advisor Wealthfront. The service is available for accounts as low as $100,000, and, as a company spokesperson told MarketWatch, the appeal of saving on taxes is a universal: hardly something reserved for the wealthy. But Wealthfront declined to say how many clients were actively using the product.
Nadig, who’s watched — and helped launch — multiple rounds of disruption in the fund industry himself, thinks a more interesting player is Charles Schwab Corp. Nadig and many other observers believe the company is moving quietly, but deliberately, toward offering direct indexing broadly, a step that will democratize it.
Schwab in June began offering what it calls stock “slices,” fractional shares that will make direct indexing much easier for smaller accounts. For big-ticket portfolios, pricier stocks like, say, Amazon.com Inc. /zigman2/quotes/210331248/composite AMZN -0.91% , aren’t a problem. But a $50,000 account that intends to invest in an index of 400 stocks requires fractional shares in order to have a position in a stock that costs $3,000.
The company had previously purchased another direct-indexing concern called Motif. And they have the enormous reach to be able to swallow low enough margins to democratize the process, Nadig said in an interview.
James Werner, a financial advisor with Austin, Texas-based Silicon Hills Wealth Management, is also carefully watching the advance of direct indexing. Werner estimates about 20% of his firm’s clients are using the service, with great success, and notes that it’s particularly popular among younger investors.
He calls Canvas “the next generation” of direct indexing capability, and says with a laugh that “the next generation beyond that” — likely one enabled by Schwab — is going to replace financial advisors like himself.
But if a bespoke, technology-oriented investing tool is going to put anyone out of a job, it’s more likely to be portfolio managers, especially those that dominate the index-investing space, sources said.
“The big loser here is not financial advisers,” Nadig said. “The big loser here is BlackRock or State Street. Their business is taking other people’s intellectual property (indexes), packaging it up and distributing them to customers.” A player like Schwab — although, in Nadig’s mind, there is no other player like Schwab, which he describes as “soup to nuts from one guy with $100 in a checking account up to hundreds of billions they manage themselves” — is uniquely positioned to integrate indexing, trading, relationships with individual investors around the country, and all the back-end machinations in between.
But Ben Johnson, director of global ETF research at Morningstar, thinks calling for the death of the fund industry is premature, if only because of the enormous inertia that surrounds investor decisions. Johnson also believes that the fuss over direct indexing belies a very straightforward reality: “For all intents and purposes this is just another form of active management.”
While a handful of investors will be well-served by the ability to invest according to their conscience or around their family fortunes, most people are better off sticking with a true index — that is, owning the market outright in a fund like Vanguard’s popular S&P 500 index fund /zigman2/quotes/201209218/composite VOO -1.23% — Johnson said in an interview.
“I’ve been predicting the end of the brokerage industry for 30 years,” said Barry Ritholtz, the co-founder, chairman and chief investment office of Ritholtz Wealth Management, a New York-based investment advisory with $1.5 billion in assets, and a Canvas client. Straightforward indexing “works for 90% of the people out there. This is more sophisticated and maybe a little intimidating to a lot of people,” Ritholtz said.
In Morningstar’s last annual analysis of the performance of passive and active funds, only 23% of all active funds topped the average of their passive rivals over the 10-year period ended June 2019.
That’s another important distinction about direct indexing. For all the discussion about customization, it’s still centered around the idea that investing needs to start somewhere, to participate in a broad market in some way, even if it gets trimmed or tweaked. That’s a vastly different proposition than the way many individuals approach investing — buying a little of this, a little of that, rolling over something from an old account, and so on.
And as Ritholtz points out, it’s much easier to implement a robust tax-loss harvesting strategy with hundreds of stocks than with a few dozen.
Still, as with any disruptive innovation it’s hard to know exactly what the future will bring. James Werner is struck by how his direct-indexing clients behaved through the March market meltdown, bringing a sense of ownership to their portfolios that he thinks was a vastly different experience than previous downturns.
“People have much stronger staying power, if they have a connection with the stocks that they own as opposed to just having things in a nebulous exchange-traded fund,” Werner said. “In conversation after conversation, people just said, I’m not worried about that, it’ll come back.”