ETF Edge - Exploring Direct Indexing

Episode Date: September 13, 2021

CNBC's Bob Pisani spoke with with Patrick O’Shaughnessy, CEO of O’Shaughnessy Asset Management and Dave Nadig, Director of Research at ETF Trends. They discussed a new investing strategy known as direct indexing – essentially, slicing and dicing preexisting indices and cherry-picking individual stocks to create a custom-made index all your own. What are the benefits and what are the burdens of such a methodology? In the ‘Markets 102’ portion of the podcast, Bob continues the conversation with Dave Nadig from ETF Trends about Bitcoin ETF's. Hosted by Simplecast, an AdsWizz company. See https://pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge Podcast is sponsored by InvescoQQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange, traded funds, you are in the right place. Every week, we're bringing you interviews and market analysis and breaking down what it all means for investors. I'm your host, Bob Pazani. Today on the show, we'll give you the scoop on a new investing strategy known as direct indexing, essentially slicing and dicing. pre-existing indices and cherry-picking individual stocks to create a custom-made index all your own.

What are the benefits? What are the burdens of such a methodology? We'll ask two experts to break it all down. Here's my conversation with Patrick O'Shaughnessy, CEO of O'Shaughnessy asset management. Dave Naughey is the director of research at ETF Trends. Patrick, we always have to do an explainer on how this works here. You can slice and dice the S&P 500 essentially or any other index any way you want. So explain this briefly to us. Well, I would just think five years ahead to the future. This is a technology trend.

In five years, you're going to get to own a custom index that's built entirely for you. That could be customized on a lot of dimensions, as simple as the S&P 499, you know, like you said, without Exxon, or it can be much more detailed, that you don't own stocks in the area that you work because you already have exposure there, that you don't own companies that emit fossil fuels, that you don't own certain other kinds of companies or overweight ones you prefer. There's lots of ways that we're seeing this platform get used, but, Fundamentally, it is a technology trend, just like ETS were, just like mutual funds were, as a better way for people to get access to the stock market. Dave, this would make sense for a number of different things. But the one thing I think of is, for example, an ESG account, environmental, social, and governance account. You can essentially create, you know, the Bob Pisani ETF that only contains my personal beliefs in ESG investing, for example. So talk to us about what direct investing lets you do here.

Yeah, I mean, you hit the nail right on the head, right? One of the big problems with ESG is it's so personal. I may care a lot about animal welfare. You may care about climate change. Not that we shouldn't care about all these things, but we may want to invest differently based on our beliefs. Very hard to do that with a big packaged product, even though we've had just tons of those types of products launched in the last year. In a direct indexing environment, you can literally move a slider around and say, hey, I really want to take carbon out of my portfolio, I don't care so much about tobacco stocks. That's not where I'm going to worry. So you really can create that socially conscious or environmentally conscious portfolio that's right for you, but it's still based on fundamentally sound large cap indexing, for instance. That's really the advantage here is you can choose what's important to you and capture a lot of those cost benefits. And what we know are the long-term investment benefits of a fundamentally indexed based approach. Patrick, so again, this sounds terrific on the surface of it. Sounds like investors can now design their own ETFs, but what problem is it actually solving? I know you've talked often about

the tax benefits. Is that the main advantage here? What am I getting by trying to get involved in developing my own, essentially my own index? Yeah, one of the advantages we have, given that we manage our own custom index platform called Canvas, is a huge number of accounts to see why people care. I think the question is a good one, like, great, you can customize, but what do you actually do with that? So we just have the data to show what people care about right now. A hundred percent of taxable investors like the tax features. No one wants to pay more taxes than they need to. There's lots of ways you can do this.

You could set absolute gains on how much tax you're willing to pay. You could set the index to say, give me as many losses as you possibly can so I can use those to reduce my tax bill elsewhere. But basically, everyone likes the tax benefits, and that should come to the mass market over the next five years. There's also things like ESG, but it's only about 20 percent. of the assets on the platform as we see it today that make adjustments for for things like carbon or for even tiny things like they don't want to own companies that produce sugary drinks is one funny example that we've seen but just 20 percent but for those 20 percent it's incredibly important and then lots of things in between like i mentioned earlier you know i don't want to own more capital

market stock because my whole career is tied up in that space if you work at google maybe you want less technology exposure and so on i think the dimensions of customization will proliferate through r and d over the next five years. But clearly the demand is there for people to have their own strategy built just for them based on their circumstances and their preferences. So, Dave, Patrick's been talking about tax lost harvesting as a main feature of this. Does tax management here really add any alpha? Do you actually, can you show that people are doing better under it? Yeah, absolutely. It can. There have been a number of studies on this. And obviously, it depends a little bit on how much transactions might be in those types of portfolios.

But there have been studies that show for somebody at the top end of the tax brackets, right, who's got potentially some short and long-term gains. You can eke a few extra percent out a year by being really smart about how you manage those tax losses. As Patrick says, this isn't something that's just for the ultra-wealthy. This is rapidly coming down towards the mass affluent market. And honestly, we'll be in the mass market market really very quickly. Schwab's developing product here. Fidelity's been developing product here.

a lot of smaller direct indexing software providers get gobbled up by big ETF issuers. So I think it's a bit inevitable that we're going to get to this more customized way of approaching investments. It really is solving real problems for investors. You know, Patrick, it seems like this could not exist without two things having happened recently. The rise of commission-free trading, frictionless trading almost, and fractional share stock investing, right? Doesn't that allow the investors to purchase these fractional shares in a certain dollar amount. Without these two things, how would you do this? It would be prohibitively expensive, wouldn't, or even impossible to buy the fractional shares,

right? Yeah, one of my favorite terms is directional arrows of progress from my friend Josh Wolf at Lux Capital, the idea that in technology, there are certain arrows of progress that are just sort of inevitable. We saw the march towards zero cost trading. We've seen the march towards fractional share opportunities, but also towards just falling operational costs on a per-account basis that used to be shared by the ETF or the mutual fund, now those costs can be very low for the individual. As you get lower and lower costs, lower frictions, that unlocks these big opportunities.

So you're right. These things couldn't be possible without these trends in technology, but the trends are inexorable. They're going to keep happening, and then some that enable this more custom way of investing in the future. You know, Dave, I see sort of three things here.

Number one, this makes most sense in a tax-managed account because of the tax-lost harvesting, sort of less sense in a 401K, for example. Number two, this can get very complicated very quickly, a lot more complicated than most people want. And third, the expenses still can get away from you. Aren't you trading a lot potentially? I mean, you're becoming an active manager. I'm sorry to let my inner Bogle, Jack Bogle, out here, but isn't that an issue?

Well, it could be an issue if you constructed one of these things incredibly poorly, right? You can't put a 100% turnover strategy into a direct index and with a straight face, call that indexing anymore. The idea here is to capture some of those great benefits of indexing, a lot of which have to do with minimizing that turnover in the first place. So it's really a balance between all of these competing things that you're trying to get out of your portfolio. Taxes aren't everything.

You're right. This makes the most sense in a tax-aware account, a taxable account. But the other benefits we're talking about still matter. I've talked to several large investors who've used this to manage down large single stock positions that they managed to put in a retirement account, but they still had to figure out a way to sell down over time in a logical way. Products like this or programs like this really solve those problems for larger investors and for smaller investors. I think there are going to be a lot of efficiencies in the corners that we're not really even looking at right now. Being able to manage

precisely to your needs really does matter in the long term. Yeah, you really have to have an opinion, though. Now, Patrick, you have a custom indexing platform you referenced earlier, Canvas, and this allows financial advisors to build individually tailored client portfolios in SMAs and separately managed accounts. Tell us how that works. Yeah, so functionally, if you think about ETFs like the Model T, you can have any color you want as long as it's black.

You know, you get sort of one-size-fits-all. Canvas is sort of the opposite. It's very similar to going online and building a Tesla or something on their website where you get to sort of pick the rim color and pick the exterior, pick the interior. There are even more options than that in a custom index. But it feels like that. It's very simple process, actually, a lot of the dimensions that we've already talked about. But you go through an online workflow and then you end up with a rule set. And then it's self-driving from there.

A firm like ours or many others will come to the floor that do this as well. Think of it like self-driving money, right? Like you set the rule set, you set the conditions for yourself or your own personal index. And from that point forward, the firm manages the trading, whether that's tax loss harvesting, complying with some custom requests that you have, et cetera. But to the advisor and eventually to the end investor, it'll feel like just the next generation of any technology, just like using Stitch Fix for customized clothing or, like I said, building a Tesla online.

So I still want an easy. Go ahead. So the other thing, too, is it really doesn't get much more expensive. I think that's a critical component. You mentioned, like, our fee is going to get out of hand. I suppose you can imagine a world where the spreads on the trading might, hurt you, but you know, the ETF has to play in that game, too. The kinds of expense ratios we're talking about at the end of the day don't look much different than what we're seeing in the middle

of the pack on the ETF market. Can you do it for three basis points? Not today. Can you do it for 20, 30, 40? Absolutely. Yeah. So, Patrick, I want to go back with the example. I brought up the EESG as an example, but show me, walk me through a portfolio. You run this canvas platform, right? Well, what's popular strategies on the Canvas platform? Give us a little mental model about what typically the people are doing on that platform. Yeah, sure. Maybe I'll give one that has sort of two components that are quite different from one another that were designed early in 2020 pre-pandemic.

So this was a taxable account. It was one that did – it's one of the 20 percent that did care about ESG. So it was set to avoid companies with certain criteria, most specifically fossil fuel, carbon emission exposure, so to underweight companies with the worst offenses there, but also to generate as much after-tax benefit as possible, meaning when there was an opportunity to trade a position at a loss, do so that I can book that loss and use it to lower my tax bill elsewhere come the pandemic in March and April of 2020. And what you see is this very quick reaction of the custom index

to sell those positions and generate a multiple percentage point after-tax pickup benefit while also managing something like the ESG exposure. So that's just two dimensions that were custom for that specific account. It was a broad market exposure. Think of it very similar to the S&P 500 just with these two key adjustments for this particular family. And again, we're seeing tons of different examples just like that one, but it allows you to react to changing market conditions versus just hold a simple exposure that can't generate things like tax benefits and customized to the person's circumstances. So other than the 20% that are using it for ESC purposes, is there any generic other group of people that are using it for a

specific purposes? I mean, is most people taking an S&P 500 index fund, or are they using other indexes and building customs around other kinds of indexes? Any trends that you're seeing? I'm trying to get a sense of what people are doing with all this. So the beauty of the flexible platform is it's all over the map. So yes, some look kind of like the S&P 500. Others look like the MSCI Acrea, World Index. Others look like a 50-50 large cap, small cap, wanting to tilt more towards small cap. So you can use it to create a custom asset allocation at the high level, if you want, and lots of people do that. At the more micro level, we also see ton of risk management customization happening. So we already mentioned this idea of, let's say it's a Google executive or an Accenture

executive that has a big stock position in that one company, and obviously their earnings associated with that company. We see tons of people adjusting for that in their portfolio, and we basically shrink away from similar companies. So, you know, we own Google, own less Facebook too, and towards companies that are more complementary and different in their risk profile. So everyone's risk is a little bit different based on what they already own and what they do with their career. We can also adjust for that, and that's a third thing we hadn't talked about yet, which is very popular.

Yeah, so, Dave, if you're picking your own stocks and you're creating, you know, the Bob ETF, what's the benchmark? How do I know how I'm doing? Or is that a silly question? I get confused. The word index is in this for a reason, right? We've been managing separately managed accounts since the 50s, right? But the reason we call this direct indexing is you start with the idea that there's a piece of an intellectual property that you want to follow, call it the MSCI Acqui, right? That's thousands and thousands of stocks. You obviously don't need to own thousands and thousands of stocks individually, so you can use something like Canvas to winnow that down to just getting the actual real economic exposure with these twists on it. But then once that's set, it really is like an index. There's

nobody picking and choosing stocks on a week-to-week basis. This isn't active management. It's software. That's really what we're doing. We're taking the same indexing software that's been used, say, at BlackRock forever to run their funds, and we're bringing that down to the individual account level. That's really what's happening. It's just bringing that massive software down to effectively an app on your phone. Right. And Patrick, in the discussions I had with you, you wanted to make a difference between direct indexing and custom indexing. This is a little in the weeds, but you made this very clear. Direct indexing is you pick the index, whatever index that might be, the S&P 500, Futsi, whatever,

and you run the tax law strategy with those holdings that you pick out of that index. The research portion for direct indexing is done essentially by the index providers. They have the index. Custom indexing uses in-house researching, essentially. So you can target anything you want, if I want to target a 2.5% dividend yield. Is that an important distinction, this difference between direct indexing and custom indexing? I think it's really important, and that you'll see the leading firms go more towards the custom side than the direct side. And I would think about it in really simple terms.

Does the firm doing this for you, us or somebody else, do they control the research or not? In the case of direct indexing, it's like you said, it's outsourced to S&P or Russell or MSCI, and those indexes are the baseline off of which you can then, you know, make little small tweaks. We think it makes much more sense to go from the bottom up, build exactly the strategy that the customer needs and use in-house R&D to do that. That allows you to do a lot more small, granular, flexible things. It also allows you, I think, to just do a better job of moving quickly and accommodating new investor demands as they come out, not waiting for a third party to update their index methodology. And I would think about this just like ETFs.

the vast majority of ETFs are not market cap weighted exposure. There are some index methodology that somebody somewhere designed and maintains and occasionally updates. We would rather that our investors not be at the whims of those research people and those designers, but rather control that in-house so that we can give customers exactly what they want. Yeah, Dave, I want to switch topics a little because I want to get your thoughts on something to happen on Friday. The Senate Finance Committee on Friday proposed a raft of loophole closures around some of these these systems and ETFs. And one very specifically targeted was the in-kind redemption tax treatment, ETFs rely on. I've gotten some questions about this. Can you explain this simply?

What is this about how in-kind redemption tax treatment works and how this would affect the ETF owners if it passed? Yeah, sure. If you're an ETF owner, generally you don't get any capital gains distribution from the fund company because when money comes out of an ETF, the company can push out their lowest basis shares, the ones that there would be a taxable event on. That's part of the creation of redemption mechanism. It's been that way since 1993. It's not something that's brand new. It actually dates back into the 40s, if you really trace it all the way back. There is a specific line in the Internal Revenue Code that says mutual funds and ETFs can do this. Senator Wyden in his proposal says, let's just cut that line out of the Internal Revenue Code. It's very simple. It's literally

one sentence. But what it would do, it would mean that that window goes away. You can no longer redeem your low basis shares. So it puts an ETF and a traditional mutual fund pretty much on the same footing, which means if somebody has to sell inside the portfolio, there's a taxable event. So if I owned a Vanguard tech ETF fund, right now I pay almost no capital gains until I actually sell anything, of course. But if they eliminate this, it means you'll get a taxable gain distribution if they sold to meet any redemptions, just like a mutual fund. Yeah, not only to meet redemptions, but also just rebalancing, right? I mean, almost all of these funds have some sort of rebalancing mechanism in them, except for, you know, the most

generic cap-weighted exposures. Every time that happens, it can theoretically create a taxable event, which you then have to pay for whether or not you did anything, whether you sold anything. So that's why we've always said ETFs are more tax-faire, because you, as the investor, determine when to sell. Yeah, and not to ask a silly question, but why are they doing this? Why are they trying to close this loophole? And what are the chances that's going to get enacted? I think the chances are fairly low. It's easy to look at this and say, well, gosh, this is a thing that rich guys are taking advantage of. It's actually smaller investors that benefit the most from this. High net worth investors generally have lots of ways to shelter taxes.

ETFs are convenient, but by no means the mainstream of how high net worth investors manage their taxes. situations. But if you're a smaller investor who's been accumulating some money outside of your 401k, ETFs have been a great boon. I think that this is pretty regressive. And for that reason, I think it's pretty unlikely to pass. But the reason to try to raise revenue, obviously. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is the Market's 102 portion of the podcast. Today we'll be continuing the conversation with Dave Nautic from ETF trends. And Dave, I want to have a slightly different subject than what we were discussing prior to this with direct indexing, and that's what's going on

with the SEC and Bitcoin ETFs. Gary Gensler, the head of the SEC, is going to be testifying tomorrow in front of the Senate Banking Committee about what the priorities are for the SEC, and he's made it very clear that crypto is one of his priorities. Unfortunately, he seems to be sending out signals of great concern about the Bitcoin ETF. You, and I know you and I talk often, and you have turned rather negative on the prospects for a Bitcoin ETF. Tell us why. Well, I would say that Gensler hasn't just gone negative on Bitcoin ETFs. He's gone negative on crypto, period.

The comments that he made, particularly to the Coinbase request to launch their lending program, which is a pretty straightforward thing in the crypto space, lending your Bitcoin to somebody else who then wants to short it, I mean, this is, you know, or just lending it out to people for whatever purposes so that they can use it in some other part of the crypto ecosystem and gaining some sort of, you know, interest rate on that loan, a little bit like stock loan we do in the traditional securities market. It's a pretty normal use case in crypto outside of Coinbase. There are hundreds and hundreds and hundreds of ways to do that kind of lending. And the response from the SEC was more than just negative. It was a wealth notice. It was basically saying, you will be.

in violation if you try to do this thing. It's about the most aggressive thing the SEC can do short of actually bringing enforcement action to somebody. I mean, pretty much everything that went down with Wells Fargo, if you remember, happened through notices like that as well. So that is a, it's a pretty bold statement from them to come out and say, you just simply cannot do this because this puts you in the securitized realm. Because if that's in the securitized realm, then I would say most of what people are actually doing that's interesting in, quote, unquote, defy, decentralized finance is also going to hit that realm. And that if the SEC's opinion is all of these things are patently illegal for U.S. investors, that's a pretty big statement. And I fear that's really what we're getting at a Gensler right now is that kind of bold statement that says, hey, crypto is just off sides for U.S. citizens filing U.S. tax returns.

That's not what I expected. I actually expected a bit more of a bridge. Well, what I see going on here, and I agree with you, they're essentially saying lending Bitcoin is a security. And if that's the case, then almost everything else is security as well. So they're taking a – this is not because they had a thing for Coinbase. They're taking a jurisdictional stance here. They're basically saying this is going to fall under the purview of the SEC. and we're telling you right now all this other stuff. This is basically drawing a line in the stand and saying everybody else, you guys are

potentially under our purview. Is it not? I mean, that's what they're doing. It's not because they have a thing for trying to get back at Coinbase or something like that. No, no, this isn't personal. As much as it may have felt personal to the CEO who went on a bit of a Twitter rant about this, this isn't personal.

This is, as you put it out, this is staking out jurisdictional ground. This is a little bit like when the FBI shows up at a crime scene and says, we got this. the sheriffs can go away, right? It's pretty hard to argue when the FBI shows up. It's pretty hard to argue when the SEC shows up. It's not like there's anybody you can appeal this to, really. Short of legislation, this is how it's going to go. The SEC is going to decide where it wants to draw the lines. So this goes way beyond will they approve a Bitcoin ETF. I think a straight-up held Bitcoin ETF, sort of a GLD for Bitcoin, I don't see that in the picture at this point. Until we have some further guidance about how they want to think about crypto and where it fits against the securitized part of the balance sheet, I think all of these things are on hold.

Yeah. So here's my first question, my first reaction. How did this happen? Remember, Gensler was supposed to be the crypto golden boy, right? Oh, he taught it, you know, MIT. He certainly gets it. Has something happened to him between now and then, or is actually nothing happened, but there's a big difference between being a professor at MIT and being the head of the SEC. There's different responsibilities. I mean, the community seems in shock, but should the they have been or, you know, suss to South Post. Yes. I think there's a big difference between being a professor where your job is kind of to explain the world to your students and being in a policy position. And for better, for worse, the chair of the SEC and the SEC in general is a policy organization. It may not have been designed that way in the beginning, but it is now an organization that delivers policy about how the securities markets in the United States work at a fundamental level. And that gets a little bit beyond investor protection, in my opinion. I tend to be a little bit more

laissez-faire about these things. I think financial innovation in general is a good thing. I absolutely think you need guardrails and rules, and I would love them to come out with really clear guidance for everybody in the space so everybody could understand what the playfield was like. But that's not what we have right now. What we have now is supposition based on statements made at conferences. I mean, you said it yourself. We're going to hear testimony to the Senate Banking Committee, and then we're going to try to infer policy from that, which is a little nuts.

I'm not trying to defend the SEC, but isn't this what they're trying to do now? By making these comments about the Coinbase Lending Program, they're laying out a jurisdictional stance. Gensler has already said, I've got a problem. I don't know what... There is regulatory gaps over, for example, the exchanges. We don't know who's controlling these.

Don't we think we should know who's got control over these things, regulatory control, before we go out and approve a Bitcoin ETF? This makes some sense to me. And here, they're laying out a stance, which I agree is a bit extreme, but at least they're laying out a stance. Aren't they laying the groundwork to essentially say, we have control over things like Bitcoin exchanges, and now that we have regulatory control,

now let us tell you what we need to, therefore, get to a Bitcoin ETF. Yes, I think you're right. They're going back a step to sort of a first principles approach, right? Establishing what is and is not in their purview. I think one of the other things that may have caught them off guard, and I haven't heard this directly from staff, but I've heard other people talk about this, the fluidity with which you can move money around the crypto ecosystem, I think has caught a lot of policymakers around the world off guard. It is trivial for me to go buy a million dollars in Bitcoin on Coinbase, and then move that over to a Metamask wallet that's sitting on my computer, and then open up an FTX account in Germany and start trading

the leveraged futures on Bitcoin. Now, you may break some, quote-unquote, rules in that process, but you'd be hard-pressed to find out which one you broke. Right. So, okay, handicapped this. What happens now? Is he going to approve, for example, he's indicated he would smile upon people putting in applications for Bitcoin futures ETFs because that's a regulated space. Is he going to approve a Bitcoin futures ETF this year? When, if ever, will a Bitcoin future, Bitcoin, I'm sorry, Bitcoin ETF, pure Bitcoin ETF, be approved. And it seems likely now it's not going to be approved without more regulatory control or regulatory clarity. So is that fair to say? 100%. I think before we get any of these things approved,

I would expect that we'll get some sort of communication from the staff about, it will probably come in the form of questions, as these things often do, like a request for comments. And in that RFC, people will be able to say all of their opinions about how the ecosystem should evolve, and then there will be proposed rulemaking. That's normally how big, weird, new things happen in the securities market in the U.S. That process takes years. And honestly, despite the fact we've had filings for this stuff for years, we've never really had that full conversation about crypto in general. It's been very specific to Bitcoin ETF. Sorry to pin you down so much. So chances of a Bitcoin futures ETF happening this year in the next six months. Twenty, twenty five percent in the next six months. I suspect we'll get some more kicking the can down the road. The SEC loves to kick that can. So we have a lot of filings.

A lot of them are due notices in the next 60 days or so about whether or not they're being approved. I suspect most of those will get kicked down the road with requests for more comments. And as for a GLD for Bitcoin, a straight-up, quote-unquote, physical ownership ETF, I just think it's absolutely not in the cards until we get more clarification. I think it's been backed up at least into 22, but there's no reason to particularly think any time in 22 is the magic time either. Yeah, I'd agree. Okay, Dave, thank you very much. And that's it for today's ETF Edge podcast.

I'm Bob Pizani. Thanks everybody for listening. Make sure you tune in next week. And in the meantime, you can tweet us your questions or ideas at ETF Edge, CNBC. Thanks very much for joining us. InvestcoQQ believes new innovations create new opportunities. Here's the greater possibilities together. Learn more at investco.com slash QQ, Invesco Distributors, Inc.