Animal Spirits Podcast - Talk Your Book: Direct Indexing

Episode Date: November 20, 2020

On today's show, Michael and Ben talk with Rusty Vanneman, Chief Investment Officer at Orion Advisor Solutions about all things related to direct indexing. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits is brought to you by Orion. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's Wealth Management. This podcast is for informational purposes only and should not be relied upon for investment decisions. of Ritthold's wealth management may maintain positions in the securities discussed in this podcast.

Ben and I speak with Rusty Vanaman, chief investment officer for Orion, about all things related to a topic that I think is going to become more and more prevalent in the financial services industry in the next couple of years, direct indexing. The progression is mutual funds, index funds, ETS, now direct indexing. I think what was before the mutual fund? Just Stocks? Holding individual stocks? Yeah. Bucket shops.

Man, I would have killed it in the bucket shops. Not to brag. You would have gotten crushed. You would have been the guy holding up the sign and then a great depression photo having to sell your car. But this idea of direct indexing, the fact that you're hearing more and more about it, and it's still pretty tiny part of the whole wealth management industry. But the fact that costs went to zero in terms of commissions is made it perfect for this. That was, now it's like the breaking of the dam.

Yes, we talked a little bit about what it is in our talk with Rusty, but direct indexing is simply recreating an index like the S&P 500 and potentially changing it any way that you want. You could exclude certain companies, but it's easy to mimic it by buying all the stocks or buying the biggest, whatever amount of stocks that will get you close enough to it. And then you can design the strategy any way you want. You can tax loss harvest it. You can put ESG restrictions on it. There are a lot of different customizations that you can do. using this. And I think especially for financial advisors, this stuff is just going to grow. And every custodian in the next few years is going to have an option like this. Well, especially at this

bold market, the use case is obvious. Let's say somebody put $10,000 into Amazon in 1997. And now it's five quadrillion dollars. Yeah, well, exactly. But if you've, if you've held any of these giant tech stocks over the last five years, it could potentially be a big position in your portfolio. And with something like a direct index, you can get out of that. You could pare it down that position responsibly over time in a tax-managed way that takes the emotion out of it, takes the guesswork out of it. So I think the use case is going to explode. And kind of like we've heard about ESG a lot over the past few years, right? Probably, I don't know, four or five years we've been hearing the drumbeat. But for whatever reason, adoption came very quickly in 2020. And I

wonder if we're going to see a similar evolution and direct indexing. The problem with ESG funds in the past, too, was a lot of the fund structures that you could invest in maybe didn't line up exactly with the way people wanted to invest based on their values. And now with direct indexing, you can set your exact rules in certain companies or types of companies. You can get way more granular on what you want to do in that. So I think that stuff will explode even more too within these direct index. So like you would own the S&P 500 X Starbucks. Yes. And all my target date funds, I would take out anything to do with coffee. But that's the kind of thing you could do. We talk a use case about taking, if you work in technology and take out all the tech stocks,

if you wanted to manage risk. There's a lot of different ways you can do it. So I think this tool for customization, making your portfolio different, is going to be a really big growth prospect for advisors. All right. Here is our conversation with Rusty Van derby. We are joined today by Rusty Van derbynman. Rusty is the chief investment officer for Orion Advisor Solutions.

Rusty, thank you for joining us. Man, it's great to be here. Listen to you guys all the time. It's an honor to be here. Awesome. Thank you. All right. So today we're going to be talking all about direct indexing, a phrase, two words that are going to be heard more and more in the financial universe in the coming weeks, months, and years. So for those that are unaware of direct indexing, can you please describe what exactly it is when we're talking about this concept? All right. So direct indexing, if you've never heard of it, I mean, this is going to be big. But for those you think it's going to change the entire world, maybe a little overrated. So what it is, is basically, so you have an index fund. So you could have a mutual fund or an ETF, basically on the S&P 500.

So that's an index fund. A direct index, however, is replicating that S&P 500 exposure by owning the underlying securities. Now, you don't have to own all 500. Magic. Yeah, exactly. You can own 100 of them. And then all the math behind the scenes is optimizing it to basically sort of have the same risk characteristics and the same return over time.

Is one of the reasons that direct indexing seems to be blowing up now because of the lower costs and just increased technology efficiency? What is the reason that it's all of a sudden come to the forefront? I think there's a lot of reasons. So first of all, the fact that commissions have dropped to zero is huge. But the reality of it is even before that, it was becoming bigger because the technology caught up. Once upon a time, I mean, this direct indexing has been around for decades,

but it was really available really to like huge accounts. And now you can do it with much smaller accounts. because really the math is caught up, the computational power. The fact now you throw in no commissions and also the prospect of trading fractional shares, you can basically replicate what you needed $10 million before. You can now do for $50,000. So let's back up. And if we could just talk about the evolution of investment vehicles. What came before the direct index? Actually, I love this question because I still love to defend the old school mutual fund. So first of all, the mutual fund, I mean, thinking about it. It's one of the great financial innovations. It is a diversified portfolio, professionally managed, you know, low minimums, regulated, a reasonable cost. Actually, the cost has become more reasonable in recent years. It's a great vehicle, but it's not perfect. So now, of course, the exchange traded fund is the new technology that really came about in the early 90s. And in short, the way to describe, it's like a mutual fund. You could trade like a stock. But really, it's much more tax efficient. And it's, it's much more tax efficient. And it's,

It's easier to manufacture, so you have lower expense ratios. And because the way the shareholders interact with the fund, you only realize capital gains if you sell the ETF. You could actually have capital gain distributions if you own the mutual fund. So basically what you're getting, it's the better technology over the mutual fund, and particularly for taxable investors. So it's taking away market share from mutual funds. I don't think mutual funds are going to die, but it's going to be really, really hard for

them to grow because exchange rate of funds are taking that market share. Now you have direct index portfolios. Now, I didn't even talk about some of the benefits of direct indexing. There's multiple, but one of the biggest ones is from a taxable standpoint, they're pretty cool. And so they're even more tax efficient if it's managed properly than even an exchange-rated fund. And so could it actually take away market share from ETFs? Yes, it will. Will it kill ETFs?

No. There's so many different use cases for ETFs, you know, the fact they're transparent and liquid. There's so many, like, short-term uses. But quite frankly, they're just simple to use and simple portfolio. portfolios make a lot of sense for investors as well. But again, from a taxable standpoint, if I could just break down the value there. So again, let's say we go back to the S&B 500 example, 100 securities. Now, those are 100 different tax lots. You know, is digging and zagging all over the place. Some of them are going to go down. You can do the tax loss harvesting any time of the year. You can do it on January 2nd.

You know, if you've got a tax loss, you can take that and harvest that and use that to offset future realized gains. And so basically you can create something that the industry. likes to talk about called tax alpha. And what tax alpha is, just kind of the quick computation, it's looking at the after-tax return of a direct index portfolio versus the after-tax return of an ETF of the same index. So kind of the rule of thumb is that a tax alpha could be one to two percent. There's a bunch of studies on it. Some say two, some say one. Some say like 75 basis points, but whatever, there's some genuine tax alpha. It makes intuitive sense over time. Now, obviously tax alpha numbers can differ on the type of portfolio.

You know, quite frankly, if you have a larger portfolio, you have more tax lots to work with. Small caps, I think, are a great example where you might have a higher tax alpha expectation than small caps because you got more volatile names. They are not as highly correlated to each other. So there's just a lot more opportunity to realize higher tax alpha. So anyway, that is one of the biggest advantage of direct indexing. I think a lot of people think ETS are dead meat because of it. I think that's overrated, but it is a legitimate. If you're a taxable investor, you should be looking at direct indexing.

index portfolios. I do agree that. The tax is a big thing because people just, clients hate taxes. You could make them hundreds of thousands of dollars in gains in a portfolio, but if you save them a few thousand dollars in taxes, their client for life, basically. What do you think are some of the other use cases here? And do you think that something like ESG is a huge opportunity here as well? I do think ESG is, we've been talking about ESG for how many years now, like for our entire career, so how it's going to be the next big thing. And I actually think direct indexing really could be a game changer here. And it's all on the account set up. And again, direct indexing is an opportunity for, you know, advisors to show technology how to add value

to portfolios. And it's in the customization. It's just not in the tax alpha, but in the customization, it's about risk management. It's also about the ESG. And what's really kind of the game change about ESG is that there's so many different index providers and they're getting so much more granular in their exposures. So if you feel very strongly about a certain value, you know, the indexes are kind of catching up to that. And you can really sort of pinpoint that sort of exposure. I think the problem with ESG over time, but particularly bringing it to the retail investor, is that you have this broad-based exposure. Let's just say that it's about climate change. And you get two different people in a room who both feel strongly about it. They're still going to have different definitions

about it and they may not like it. And so now with direct index portfolios is, again, you can get much more granular. I think it's to be much more acceptable and exciting to people who want to invest based off their values. Let's circle back to the tax law stuff because I think this is probably the biggest use case. Yep. Let's just keep it very simple. You've got SPY, IVV, whatever. You've got an ETF that tracks the S&P 500, pretty tax efficient. You don't sell. You don't pay taxes, basically. How does that compare to direct indexing? Let's just say that you have 200 out of 500 names, whatever, however many you're holding, and you're able to track the index because, of course, the bottom 60% of names are just a fraction. They're a tiny piece of the index.

So if you have a portfolio that's 100% SPY versus a portfolio, that's 100% direct index of the SEP 500, and you're taking losses along the way, but you're matching the index. When do those losses benefit you? Like, where does the tax alpha come from? It's a question. So basically, you just use them to offset the future gains. And you can actually use those gains or those realized losses. And it could be in other accounts as well. And, you know, basically it's a lot of times it is in the education of the advisor. The advisor has to provide the education to show that value. A lot of times to see a lot of trades, a lot of activity going on. And, you know, some people at first think, I mean, you're taking all these losses.

I mean, what are you doing here? And basically, you have to show the value of that tax loss harvesting, realizing those losses, and matching it against future gains. So one of the double-edged sword things with this is that it just introduces the paradox of choice. So I think it's great that we're giving investors all these different tools. Who do you think is going to be presenting the filters on stuff like this? Because there could be an infinite number of choices that investors make. How do you see that evolving? Well, I mean, I think it's the advisor.

The advisor in those cases, they're the ones using the tool or they're outsourcing the use of the tool. I mean, the tax self is kind of an easier concept, but some of the, I mean, the reality of it kind of behind the scenes, there's a lot of stuff going on. You come in in the morning, you know, you've got, you know, thousands of counts, you know, thousands of positions, what needs to be acted upon. And so an advisor needs to be able to kind of explain as simply as possible of what the benefits of the tax offer, what they are. Again, I think it's in the customization when the account is initially set up. It's also really important, really understanding what that investor, what he or she wants in that portfolio. Again, it isn't just about the taxes, which is huge. It isn't about the ESG, which,

quite frankly, not everybody cares about. It's also some of the risk management aspects of it, too. It's bringing in legacy positions. It's thinking about, you know, where their income sources are coming from and diversifying or hedging against that. So there's a lot of other considerations that come in. And quite frankly, that is just an opportunity for the advisor to have that conversation and build that relationship. So we'll get into all of the advisor use cases in a second. Do you think that this is something that Schwab is going to roll out fidelity, et cetera, to their retail audience? Or is that just, is it just too complex? Is that years away? Hmm, that's good question. I would imagine, I would imagine everybody is looking at it

right now. I can't imagine why they wouldn't be. You know, it's like, obviously we're doing it Orion, where there's other firms that have been doing it for years. We constantly hear of other firms that are going to be bringing out. So I would imagine it would be a service that many firms will provide. I do think going to get back to another question, too, in terms of the options. I mean, the simple options are the SB 500, but the reality is you could direct index any strategy. I mean, it could be an actively managed portfolio that somebody might have, that you could actually direct index that portfolio, which you would need there is sort of a buy list of other securities in case you're doing tax swaps. But you could basically direct X anything. And I would imagine

and you're going to see a lot of that. For example, I think one area, you know, one area I think is really, really interesting is the whole, and I think this is a whole controversial topic, is the whole topic of thematic ETFs. I mean, thematic ETFs obviously are killing it this year. The growth is amazing. Some of the returns are great. But we all kind of know the danger of the sexy story and the sizzle and the returns.

And so assuming a thematic ETF or a thematic strategy of any sort has genuine, investment merit. And so it really has, you know, legitimately attractive expected returns. It actually can help diversify a portfolio. It can actually enhance the possibility of a better risk-efficient portfolio. If it can really do all that, a lot of these thematic UTFs on a standalone basis, I mean, their underlying securities can be pretty volatile. And so that is a great opportunity for a direct index portfolio, in my opinion, again, assuming we have the investment merit in place, because instead of just having like that single ETF, which is capturing that theme now and it has all these underlying securities which are really

volatile. What if you direct index it and you're a taxable investor? That way you're participating in that theme and you also have that opportunity to realize that tax off as well. So let's talk about that. So let's say that somebody comes to you at Orion and they say, hey, I love what Kathy Wood is doing with ARC with that ETF, but I think that we can employ that with a direct indexing strategy and really knock it out of the park. Is that something that you could implement for advisors? I think that is a possibility. Yeah, you could set up.

I mean, it's like you'd have to set up a portfolio. It has to be rules-based. And you would have, that would create the portfolio. And you need a, again, you need a buy list of other names, substitute names, if you're tax managing it. And again, how it all works is then there's a trade-off between the tax alpha, the tracking error, and transaction cost. And so that is kind of what the math is doing behind the scenes, running all those iterations.

There's that tradeoff. But yes, that can be done to answer your question, this simply. And that's why I think initially Michael's question about are they going to roll it out to retail investors? They probably will. But that's just why I see financial advisors being a huge part of this because there is going to have to be so much explanation going on in terms of if you want the S&P 500 and you don't want gun makers in there. You don't want energy stocks or oil stocks or whatever it is, there's going to have to be an explanation in there that you're going to have to. there's tradeoffs between tracking error and whatever else is going on. And if you wanted to implement your own strategy and you say, I want to copy that ETF,

it's not as easy as simply doing it. You have to understand what you're getting yourself into, correct? So I guess laying those boundaries on it is important. But do you think that the investment strategy implications from this are just going to expand the universe in terms of what people can potentially invest in? Because once the technology is there and the infrastructure is there in place, I assume it's pretty easy for you on the technology side to implement most. of these strategies, like you said, if the rule's based.

Yeah, it is. It is. And also just one of the point on the handholding, too. I mean, think about, I think we all can appreciate the beauty of a simple portfolio. You know, you can build a diversified portfolio, reasonable cost, a handful of names, sufficient portfolio. Now all of a sudden, let's say you're an investor in your portfolio, your statement just blew up. You know, somebody just puts you in a Russell 3,000 portfolio, and now all of a sudden, you've got page after page after page.

So that initial setup and understanding what is going on, again, that's where somebody needs to come in because some people are going to say like, oh, my gosh, I just, I don't really, I mean, transparency, yeah, what is, I mean, it was much easier to understand I had six names. Now I have 300. So again, it takes that education up front. But again, it's for a taxable investor, the benefits are real. Well, in terms of, let's go back to like, there might be sticker shock. I don't know if that's the right word, but when people see the statement,

Is that something that accountants are going to push back on? Talk about how people implement that into filing their taxes and everything like that. Yeah, I think over the years in my experience, you're going to see accounts will push back at first if they haven't seen it before. But in the end, the economic value is economic value. But there will, there's just that education that is required. I mean, again, if you're an accountant and you're working with an investor and you can see their gain loss statement year after year and it's like one page. All of a sudden, one year, it's like it's a lot more than one page. Like, what the heck is going on here?

But again, it's just that education to get over that initial hump. Going through the process of working with you and someone came to you, does it matter to you in terms of working with new money or money that maybe people are sitting in a taxable account? They're sitting on huge gains because stocks have gone up so much. Are you almost in a better position to come in with stocks or portfolio that have a lot of gains and then try to offset those with some losses in something like direct indexing? Well, as a portfolio manager, new money, I think, is always the easiest to work with. But the reality of it, direct indexing, again, one of the benefits of it is working with

existing positions and bringing it in. So if you have an existing portfolio, all their different tax slots, and you're trying to move to a direct index exposure, the math behind it will figure out how do you get you from your portfolio to the index over time in a tax-friendly way. So quite frankly, it can work with that. Probably the other question is, let's say that one of the key, counters to a direct index portfolio is let's say that you're in it for years and it's been doing the tax off a year after year after year you've cleaned out you're not and you're not adding new

money you're not adding new money so now after a few years it's basically everything is at a big unrealized gain you know so you know people say well that's a problem with it well i would say well let's say that took five years seven years 10 years three years whatever it took obviously the the direct index portfolio did what it was supposed to do during that time frame and it's still managing risk considerations. It's still looking for opportunity for enhancing after-tax returns over time. So I think that's one of the big counters to it, in my opinion. But again, the direct-to-next portfolio deal was supposed to do. You realize a lot of economic value. And hey, it's the investor's money. So after 10 years, it's sort of, some people

call that locked up, you know, they could move it to their own brokerage account, so be it. But then it's not being risk-managed. The market's still going to have volatility. They're not going to have the opportunity to do after tax management after that. How are financial advisors actually using this with you guys? What does that process look like? What does the education look like? You talk a lot about like the math and the mechanics of it, but there's got to be some human components, right? How does this all work in practice? Advisors can really do one of two things. They can either just use the tool themselves. We have a tool that we've created. They can just actually buy the tool and they could just manage it themselves. Learn how to use the tool,

manage the portfolios, or they can outsource it to us. We have a team of portfolio managers here who can also do that for them. And it does, again, as we've talked about, it does sort of take that subject matter expert to kind of explain it up front, particularly to the new investors. And again, the magic is in the setup as well, bringing in the positions, knowing what the constraints are, know what the preference are. I mean, that's always sort of the important thing in terms of customizing a portfolio. Do you have some boundaries in place where you have a tracking error budget where you say, yes, this is yes, and P500, but if we're doing some tax loss harvesting and you're changing the names, there could be a little bit of difference here

and there. Do you have some budgets on that sort of stuff? Yep. Every account does is set up with a tracking error budget, but again, that can be customized. And so again, tracking error is really, it's an expression of how the returns differ from the benchmarks returns over time. And quite frankly, it's one of the more really important stats. I actually like calling it tracking difference than tracking error, you know, because everybody thinks there's a but there is always that trade-off between tax alpha and tracking error. And Ben, as you talked about earlier, I mean, I think people really care about the taxes. If you talked a lot of portfolio managers or risk managers, they care more about the tracking

air. So there's always that kind of that continuum and that trade-off. And again, it's in the setup. But every portfolio has a tracking error budget. Can you, so we've spoken a lot about index, index, index, index. Can you build a portfolio where you have active mutual funds alongside of the direct index? Yeah. Again, you could do a direct index on any strategy. But what you have to do is if you're going to tax manage it, you're going to have to have a broader set of securities to, again, manage it for the tracking error and tax self considerations. So let's just say that it's doing the S&P 500 type value. I don't know. We could create some sort of portfolio right here. And you would just have to broaden out the investment, potential investment universe. if you have to do tax swaps into it.

So the securities would have to be similar enough. So it can be done. But again, there's a tradeoff because obviously if you're trying to match and actively managed fund over time, the realistic expectation is going to have to be. You're going to have a wider tracking than you normally would anyway. Do you think we've talked about the ESG stuff in terms of excluding companies or including certain companies,

do you think it makes sense for someone who has an industry concentration based on their job? So they work for Google or Amazon or Microsoft. and their whole employment is tied up in tech and maybe they have some stock options. If they said, I want the S&P 500 and take out all the tech stocks because I already have way too much of my personal net worth in those. Do you think that makes sense from a risk management perspective? I personally do. I think it's part of the conversation that advisors should have with an investor is to kind of

walk through those considerations. In the financial industry, if our entire income is based off of the markets going up or down, I mean, you could argue that our portfolio should probably adjust for that accordingly. Ben is short financials. That's smart. There you go. You've had your income. I'm short multiple trading account. That's good transparency right there. All right. That's nice. So let's get back to how advisors are using this. So it's a learning process. They go to you and what does the education for the advisor look like? Is there tutorials? Are you holding

their hand through it? How does the education process look like from the advisor's point of view? Well, in our case, and I think a lot of firms do this, that do direct indexing, it starts off in almost baby steps. You have your nice glossy brochure. And then when you get a little more depth, you get a little more depth. And then finally, if you want to get to that white paper, it's there as well. So it's just, you just feed it. It's almost like a college class, I guess. There's like direct indexing 101 and 201, 301.

It's that kind of material. How long have you been doing this for? We've been doing it for three, four years. But I was aware of it back in the 90s myself, too. I thought it was really cool. Actually, at the time in the 90s, I was actually really interested in doing direct indexing, not so much on the tax alpha, but managing exposures. At that time, I was doing mutual fund wraps.

And so I was really interested in actually tax-related stuff, but sort of matching a factor exposures and stuff like that. Did not do that professionally. I mean, I was at Fidelity Investments at the time. I went to this registered investment advisor. I didn't do it. But here at Orion, we've been doing it for. several years now. And what sort of adoption have you seen from advisors? Is this accelerating recently

with trading commissions being eliminated? The interest is extremely high. Our growth rates are really impressive, but quite frankly, it's still at a small number. But it's one of those things that's growing quickly. In terms of our firm, I would say that obviously, when we do a lot of stuff, and in terms of how much of impact on the bottom line it's making right now, probably not a huge, but probably in a few years, it's probably pretty significant. Do you think that eye shares or Vanguard to be worried about their business potentially being cannibalized? Like, how big can direct indexing possibly get? You know, I probably should be able to put a number on it.

Again, I think the uses of, the use case of ETFs are, I mean, institutional investors use them in so many different ways. And I'm not sure why that would change. I mean, it's a headwin. It is a headwin for ETF growth. I don't think it's going to kill them. I don't think they would be, I just don't think they could be extraordinarily worried about it. I mean, obviously, they all want to grow and probably adapt and think about ways of participating

in it. But I just don't think ETFs have to worry. I mean, it's mutual funds that are still have got the biggest headwinds of all. Rusty, where can people go to learn a little bit more about how Orion does this? Orion.com. You know, Orion.com, we have a wealth of resources on our website. You can just drill down. And we have written commentaries. We have videos. We have podcasts. And of course, if somebody wants to reach out and call us, they can. All right. We will link to all of that. And in the show notes, Russ. Thank you so much for coming on.

Hey, thanks for the invitation. Great talking to you guys. Likewise. Thank you to Rusty. Thank you to Orion. We will link to everything in the show notes. Animal Spiritspot at gmail.com. We will see you on Wednesday.