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The Next Investment

If you’re looking for a new trend in the investment landscape that could totally change the way advisors build portfolios for clients, then start with a look backwards.  In the 1990s, advisors were focused on actively-managed mutual funds, poring over increasingly sophisticated Morningstar screens to identify the “best” funds, or the funds that would outperform the market over the next three to five years.

Then the popularity of passive investing changed the way advisors spent their time and the contents of their portfolios.  That was followed by the rise of ETFs as the building blocks of client portfolios, and once again the majority of advisors made a switch. 

The point here is that when the investment marketplace creates new and better products, advisors will use them—and that changes how they invest.

I’m once again peeking around the next corner and looking at a trend which could trigger a much bigger shift.  Over the past couple of years, I’ve noticed how BlackRock has purchased Aperio, a pioneer in direct indexing, which allows for customized ESG portfolios and very sophisticated tax-loss harvesting.  Morgan Stanley now owns Parametric, which was another index replication pioneer.

More recently, 55ip—with direct indexing technology—was acquired by J.P. Morgan Asset Management.  AffirmativESG, which makes it easy to combine direct indexing with ESG screening, was swept up in the Goldman Sachs acquisition of First Affirmative Financial Network, and then Goldman allowed FAFN to buy itself back, but kept co-ownership of the ESG technology.  LPL Financial acquired Blaze Portfolio last year and now has direct indexing capabilities.

And meanwhile, Robinhood has launched a direct indexing solution for retail investors.  And meanwhile, the custodians are all moving to fractional share trading, which facilitates what are really index replication solutions with customization features.

You probably noticed how often the term “direct indexing” appeared in those last three paragraphs, and I don’t think it’s a coincidence.  I can envision a very near future when these large organizations will offer a “product” that is actually an individualized portfolio, customized perhaps by each individual investor checking some boxes that show their ESG preferences, or how many individual stocks they want to own, or which index they want the portfolio to replicate in terms of risk and tracking error.  They’ll get something that has been, until recently, impossible for an institutional fund company to provide: a customized tax overlay, where the software automatically searches for tax-loss harvesting opportunities for each investor, using a variety of sophisticated algorithms that determine whether the harvesting is likely to produce an enhanced after-tax return based on the client’s marginal tax rate.  The system might search every three months, every week, or even every hour.

You can envision advisors creating portfolios, not out of ETFs, but out of a diversified mix of direct index “products” that each provide tax alpha.  This, of course, shifts some of the services that the advisor has traditionally provided (well, over the past decade, anyway) over to the institutional fund manager, and further commoditizes the advisor’s portfolio management offer.  Like mutual funds before them, ETFs will be gradually disintermediated, slowly at first, then all at once.

It’s possible that this trend might, at some future point, bring back the concept of active management, because fund providers might allow checkboxes that would allow for screening out of or into certain kinds of stocks, letting them put a value tilt on the index, or weed out companies with low bond ratings (or high ones)—or any number of other things.  The fund company analysts could add boxes based on their ongoing research; that is, you check a box that would activate certain active management screens, while maintaining a portfolio weighting consistent with the index.

Yes, this is all speculative.  But it also illustrates how technology has the potential to upend what are now established portfolio construction procedures. 

We hardly noticed the shift from actively-managed funds to ETFs, but if you look back on it, the change was significant.  There is no reason to think that this evolutionary process, driven by increasingly sophisticated technology and the constant search for a marketing edge, will ever come to an end.