Orion Advisor Services is expanding its portfolio accounting technology with a new feature to make it easier for advisers to build portfolios using direct indexing.
Direct indexing involves replicating the performance of an index by purchasing the underlying shares instead of an ETF or mutual fund. It has been around for decades as a more tax-efficient alternative to index-based mutual funds and ETFs, but until recently was only available to the ultra-wealthy due to the intensive manual labor.
Orion's Advisor Strategy and Tax Return Optimization, or ASTRO, automates much of the workload, making it possible and cost-effective for advisers to create customized, separately managed account portfolios for clients, said Eric Clarke, Orion chief executive officer.
The primary advantage of direct indexing is tax efficiency, but Mr. Clarke said ASTRO also lets advisers apply customized tilts on indexes, incorporate legacy stock positions into model portfolios and accommodate a client's environmental, social and governance requests. What used to require hours of work by the adviser, or outsourcing to an SMA provider, can be done in a matter of minutes, he said.
ASTRO runs on Orion's Eclipse trading platform, which is custodian-agnostic.
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The tool can also create a performance comparison of the client's current portfolio, a benchmark portfolio, and an optimized portfolio. This can be used as a prospecting tool through an integrated client relationship management (CMS) tool like Salesforce or Redtail.
"Quite frankly, prospects are going to be favorably impressed with what these advisers are doing to build custom portfolios for them," Mr. Clarke said. "I think in this era of trying to figure out how to help advisers add value to the client experience, this is a huge way to do that. The individual investor is not out there building optimized portfolios and replicating indexes."
Orion isn't the only technology company hoping to bring direct indexing down market.
Digital adviser
Wealthfront was an early entrant, adding direct indexing to its service in 2013 based on
advice from Burton Malkiel, the company's chief investment officer.
Wealthfront initially limited direct-indexing to investors with at least $500,000, but has since lowered the minimum to $100,000.
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"Software is perfect to implement a feature like direct indexing because it's based entirely on a set of rules versus needing judgement," said Kate Wauck, Wealthfront head of communications.
More recently, robo startups like
RobustWealth and
Smartleaf have made direct indexing a central feature of their adviser-facing digital advice platforms.
Parametric Portfolio Associates, a pioneer in direct indexing that used to reserve the strategy for clients with a net worth of at least $100 million, now has a technology offering, Custom Core, that brings the minimum down to $250,000. These platforms generally make money off direct indexing by charging advisers basis-point fees on the assets they bring onto the platform.
Proponents like Smartleaf president and co-founder Jerry Michael say making direct indexes practical and affordable for mass affluent investors creates
"a superior alternative to ETFs for most investors." He said they have higher after-tax returns and are cheaper to launch and maintain.
Smartleaf claims that a five-year back test found direct indexes added 1.93% in tax alpha per year compared to ETF counterparts.
The advantages are more striking when transitioning a legacy equity portfolio into an index. ETFs require liquidation of existing holdings, which Smartleaf's study found would cost an average of 7.21% of portfolio value in taxes. Transitioning to a direct index in a tax-sensitive manner would cost an average of 0.21%, according to Smartleaf.
RobustWealth founder and CEO Michael Kerins believes direct indexing will soon be a big trend, and compared it to how ETFs disrupted the mutual fund market. If it can attract enough interest among advisers, it could potentially threaten the existing market for fund providers, he said.
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SKEPTICS REMAIN
Betterment's director of behavioral finance and investments, Dan Egan, is intrigued at direct indexing's potential for customization and disintermediating the fund providers, but says it's not a high priority for
Betterment.
"For most people, the value of aggressive tax-loss harvesting isn't that great," Mr. Egan said, adding that asset location was a higher priority for the company because it works across Roth IRAs and 401(k)s.
"From a
financial planning and investment management point of view, giving something that adds tax alpha across both of them was far more powerful. That's the issue with direct indexing – it's limited to taxable accounts," he said.
There could be hidden costs to direct indexing, including larger bid-ask spreads, and higher tracking error is riskier than direct indexing proponents admit, he said. There's also a chance to create new conflicts of interest.
"Something I would be suspicious of: if an adviser doing something like this is compensated for order flow," Mr. Egan said.
The large ETF providers don't seem to feel threatened by a rise in direct indexing.
In an email,
Vanguard spokeswoman Carolyn Wegemann said the company has examined the concept over the years, but "ultimately concluded that we are satisfied with the construction methodologies, objectivity and credibility offered by independent index providers, coupled with the reasonable cost arrangements that we've negotiated on behalf of our clients at this time."
"There are also costs, data and regulatory issues associated with self-indexing, such as the need to obtain exemptive relief," Ms. Wegemann added. "We will continue to explore any means of lowering the cost of investing for our shareholders that doesn't sacrifice the integrity of the fund."
Mr. Clarke doesn't think direct indexing is going to take down the ETF market any time soon, but said ETFs will play a different role in portfolios as more advisers embrace direct indexing. This could happen sooner than many realize.
"Between now and the end of the year, I think you'll see advisers deploy [direct indexing] with technology," Mr. Clarke said. "I think it's the first of many waves of seeing technology to help advisers automate portfolio construction. I'm not sure what's next, but we're trying to figure that out now."
