SAM News

Q&A from "A Primer on Implementing Direct Indexing"

Posted by Gerard Michael on August 19, 2021


Answers to audience questions.



Smartleaf Asset Management (SAM) hosted a webinar,  “A Primer on Implementing Direct Indexing”, a conversation between Jerry Michael, President of SAM and Doug Fritz, President & Founder of F2 Strategy. The webinar was originally broadcast on Friday, May 21st.

The audience submitted lots of great questions, but we did not have time to answer all of them live. We answer them below.


Q: What, if any, flexibility does an advisor with a self-directed SMA lose given the trading efficiency of ETFs?

A: Assuming your custodian supports fractional shares and $0 commissions, very little. If you include tax efficiency as a component of trading efficiency, the direct index is (potentially substantially) more flexible. Major ETFs (e.g. SPY) will likely continue to be more liquid than the underlying constituents. This will be relevant to hedge funds and other high-volume traders, but not for wealth managers. 


Q: What is the cost of direct indexing? What does SAM’s cost structure look like?

A: SAM’s fees range from 25 bps down to 10 bps, inclusive of all customization and tax management. Over time, we expect fees across the industry will continue to drop at or below the cost of comparable ETFs.


Q: What custodians do you work with?

A: Schwab, Fidelity, Pershing, Apex Clearing and Interactive Brokers (IB). We are planning to expand this list.


Q: What are your thoughts on the possible use of options overlay strategies used opportunistically on direct indexing portfolios, e.g. call selling in a range bound or downward market environments?

A: This is outside our area of expertise, and we may be misunderstanding the question, but we would think overlay strategies would be less useful with direct indexes than with ETFs. Options on the underlying indexes will not necessarily exactly match a customized direct index portfolio, and options on individual securities are expensive. 


Q: What are the limitations of using foreign listings vs. ADRs for international exposures?

A: The limitation of ADRs is that you get imperfect coverage and, sometimes, less liquidity. That being said, ADR-based direct indexes seem to work well. Except for emerging markets, you can get pretty good international exposure using just liquid ADRs.


Q: What advisor is able to charge less than a Vanguard fund or SPDR? Or what advisor would be willing to index and charge that little for the amount of work they are doing? You'd have to justify your higher fees in some other way/service. 

A: If the question is how should an advisor compete with robo-advisors or clients self-investing in ETFs, direct indexes are helpful, but they're not a silver bullet. That's not really a statement about direct indexes. We don't think that "products", in general, can serve as a sustainable basis for advisor value. Advisors should be charging not for product but for, well, advice, e.g. financial planning; coordinating the activities of the client's CPA, insurance agent, trust & estate attorney; weighing in on major financial decisions; basically, acting as a lifetime financial coach. 

That being said, reasonably priced direct indexes should outperform a Vanguard fund or SPDR on an after-tax expected basis. Plus, they’re customizable for ESG and risk. So, from an advisor's perspective, they're strictly preferable to ETFs. 

Lastly, direct indexes need not be a lot of work for advisors. In fact, they should be no extra work at all. The work can be automated and/or outsourced.


Q: I'm confused, if you customize an index a lot, doesn't it then just become an actively managed fund/SMA and no longer an index?

A: The answer depends on what we mean by "customize". If I eliminate IBM from my portfolio because I work for IBM and don't want further exposure, or if I eliminate tobacco stocks for ethical reasons, my portfolio returns will be different than the index, but neither action would be considered "active management" as the term is commonly used. On the other hand, if I eliminate IBM and tobacco because I think they'll have poor returns, well, that arguably *is* active management.

But all this is perhaps just semantics. Yes, customization, whatever the motivation, will cause tracking error relative to the index. It doesn't really matter if we call this customization or active management. As long as investors are informed up front that their customization choices may cause return variation, investors are well served. We do think this disclosure is important. If a client asks for, say, a Catholic Values screen, they should be given some guidance on what tracking error this might cause. 


Q: What about the systematic advantage that ETFs have in terms of custom baskets/in-kind transactions during rebalances? Doesn't direct indexing face capital gain issues that most ETFs avoid?

A: I think this is backwards. With respect to capital gains, direct indexes are strictly superior to ETFs. Let's look at three separate cases:

  1. The client starts with a set of legacy holdings: with a direct index, you can build the index around these legacy holdings. With an ETF, you would have to sell them all and buy the ETF (unless, best case scenario, the legacy holdings comprised the complete holdings of the ETF, in which case you could exchange them for the ETF; but even this case would only put ETFs on par with direct indexes).
  2. Withdrawing cash: with a direct index you can choose to preferentially sell those positions with the least gains. This selectivity should be balanced against additional tracking error, but that's just part of managing a direct index. In contrast, with an ETF, you'd have no choice but to sell the ETF, effectively selling a portion of every position in the index pro rata.
  3. Rebalancing at the asset class level: here, direct indexes are especially advantageous. Suppose you want to sell large cap, which has appreciated, and buy mid cap. With ETFs, you'd have to realize capital gains. In contrast, with a direct index, you have the option to selectively sell positions with the least gains — even losses. In addition, there's nothing to be gained by selling the smallest large cap stocks just to buy the largest mid cap stocks — there would be no net effect. With a direct index, you could selectively sell only the larger large cap stocks and buy only the smaller mid cap stocks.


Q: How does the average retail investor use direct indexing, i.e., if you are on Robinhood, etc. can you automatically opt in to direct indexing an ETF?

A: Direct indexes are not simply baskets of securities. They're *managed* baskets of securities. The value of owning direct indexes comes from tax management and customization, both of which require active oversight and trading. Therefore, the only way for retail investors to effectively own a direct index is to work with an advisor. This could be a robo-advisor (like Wealthfront, which offers direct indexes), but it is still an advisory relationship.

An open regulatory question (open in the sense we don't think an answer is known) is whether an automated trading program that generates direct index trades but seeks the retail investor's approval for every trade would be considered an advisory relationship. The question is not whether such an automated program is possible — it is — the question is whether the SEC would deem such a program to be advisory. 


Q: How do you monitor when to rebalance?

A: SAM leverages the automated rebalancing platform of its parent, Smartleaf. This means we use a cost/benefit approach. We monitor every portfolio every day and compare the potential benefits of trading (such as lower drift and loss harvesting opportunities) against the costs (commissions, bid/ask spread and taxes). We trade whenever the benefits outweigh the costs by a preset threshold. All of this is automated. 


Q: How do you measure whether the impact of taxes from selling out of your ETF and moving to a direct index is worth it?

A: Great question. It would be counterproductive to sell an appreciated ETF and generate large capital gains just to invest in a tax sensitive direct index. We compare the costs of selling the ETF with an estimate of the benefits of owning the direct index. Roughly speaking, we aim for a payback period of one year or less. This type of trade-off logic is not an exact science, since some of the benefits, like ESG customization, are intangible. 


Q: How do direct index holdings show on the customer statement, detailed holdings for pages or an abbreviated name for the index?

A: The holdings would show up as a detailed list of holdings for pages (though I suppose this may depend on the custodian). There are two ways around this: 1) use reduced set indexes, e.g. a 70 stock index that tracks the S&P 500, or 2) use electronic statements. This is a drawback of direct indexes, but it doesn't seem to be a severe one based on our conversations with advisors who use direct indexes.

Q: To sell this, should the advisor send routine reports of the "all in" fee to clients? 

A: I'd say yes. Fee transparency,  i.e. making mutual fund and ETF fees explicit and transparent,  levels the playing field and works to the advantage of advisors who use direct indexes.

Q: How do clients and advisors access direct indexing managers?

A: Most SMA programs offer access to direct indexing programs, but these tend to be expensive, so much so that they start to undermine the case for owning direct indexes instead of ETFs.

New players are bringing direct index fees down. SAM charges 25 bps to 10 bps, inclusive of all customization and tax. And we expect fees to continue to decline across the industry.

Q: Does Smartleaf Asset Management have any performance attribution capabilities? 

A: No, though we do generate an estimated Taxes Saved report for each account detailing how much active management has saved the client in taxes. 


Q: How are dividends handled?

A: Dividends are distributed back into the account by custodian. The direct index manager reinvests any excess cash automatically as part of the ordinary management of the account.


Q: How about performance tracking?

A: There are two basic choices here:

1. {Most common} Manage the portfolio holistically, with a direct index core complemented by ETFs and mutual funds for peripheral asset classes. Report the return of the portfolio as a whole, as reported by the custodian or using your own performance reporting system. Provide performance attribution, i..e. returns by asset class, if feasible and desired. But do not provide "sleeve-level" performance of each individual direct index.

2. {Less common and less desirable} Create a separate sleeve, partition or subaccount for each direct index and separately report the performance of each sub account. This second approach may seem more intuitive and therefore preferable. There are three reasons why the use of sleeves with direct indexing is undesirable (and why the dominant direct index managers don't use sleeves): 

  1. Sleeves are expensive to maintain, which runs counter to the low-cost advantage of direct indexing. 
  2. Dividing a portfolio into sleeves degrades the quality of tax management, which runs counter to the tax-efficiency advantages of direct indexing.
  3. Given that direct indexes are meant to be customized, it's not clear what information would be gained by a sleeve-level reporting. 

You’re getting a report on the combined contribution of the index’s return, the return impact of ESG customization, the return impact of risk customization and the impact of tax management. And it’s not clear how you would use this to make useful decisions (Our parent company, Smartleaf, has written about the disadvantages of sleeves here).

Q: Any guideline to provide for customization, say, within a 10% range? 

A: Yes, we think this is an important idea. You want to make sure that customization is kept within reasonable boundaries. How much customization is too much isn't always obvious. Are 5 social screens too many? How about 6?

In our own system, we're building in metrics of the impact of customization, and we're planning to enforce limits of this sort (e.g. you can't eliminate more than 10% of holdings).


Q: Can you elaborate on the obstacles to direct indexing for bonds?

A: Direct indexing with bonds isn't impossible, but it's harder. The problem is liquidity. You need to be able to buy and sell the constituents of the index for each account, possibly in small lots. That's probably OK for, say, Treasuries, but difficult for municipal bonds and most corporate bonds.

Q: I understand that ESG and security screens are applied to equities but not to fixed income. How do you justify that to the client? 

A: If we understand correctly, the question is asking about inconsistencies that can arise when you apply a screen to equities but not fixed income. So, for example, you remove stocks issued by tobacco companies, but keep bonds issued by the same companies. We agree that this is a problem. It doesn't really make any sense to do things this way. Having said this, our experience is that investors understand that inconsistencies of this kind can arise. Eventually, we expect that direct indexing capabilities will extend to fixed income offerings, but this is still a ways off, at least at scale. 


Q: Has SAM been in discussion with any IBDs about providing their service, and if so, are you able to say whom? I'm an advisor associated with LPL, and this would fit well with several of our platforms and the direction of the platform I use most. 

A: Not yet, but we're working on it. 


Q: ETFs provide scale, which can keep the cost of managing low. How can direct indexing compete, since direct indexing is a custom solution and customization is costly?

A: This is a really important question. The answer is: customization need not be costly. It can be fully automated. At scale, most direct indexes, even with customization, should be less costly than comparable ETFs. Without this automation of customization and tax management, direct indexes would be a niche offering. 


Q: Is there an analysis that shows how much direct indexing beats ETFs after tax?

A: Yes. Our parent company, Smartleaf, has published an analysis here. Parametric has published a white paper here. Aperio, here


Q: ETFs/MF IP comes from index providers or, for active strategies, asset managers. Where does the IP for direct indexes come from?

A: The basic answer is that it's the same. The IP for the index (or, more generally, the equity mode) comes from index providers or asset managers. Muddying the waters a bit, downstream users may modify indexes or create reduced-holding models of their own designed to track larger indexes (SAM does this with its SCM-S70 and SCM-S150 models, which are designed to track the S&P 500 with, respectively, 70 and 150 stocks).


Q: Do different platforms use different software to track an index? Are they using third-party tech to track an index or developing their own?

A: Yes, different platforms use different tech. Some use proprietary software. Others use third-party tech. SAM and multiple other firms that manage direct indexes use the automated rebalancing SaaS platform of SAM's parent, Smartleaf. 


Q: Do you provide the backend ESG score/screen or do I, the advisor, have to provide that? 

A: SAM provides the backend ESG screens.


Q: Can we get in-kind disbursement of ETF holdings for small accounts?

A: Not that we know of (which is a shame — it would make conversion from ETF to direct indexes MUCH easier).


Q: Who are your biggest competitors in direct indexing?

A: Parametric and Aperio.


Q: What do you use as a source for your ESG screens information?

A: SAM uses MSCI.


Q: How do you deal with the annoyance of clients receiving 1000 proxies?

A: Interesting question. We understand the concern, but we haven't heard feedback that this is a problem.


Q: How long does it typically take for tax loss harvesting opportunities to present themselves, and how often do they do so?

A: It, of course, depends on the market. But given normal market volatility, we would expect substantial benefits in the first year. 


Q: Can the SAM platform be used to manage qualified plans?

A: Yes, If qualified accounts are managed jointly with one or more taxable accounts, the qualified accounts can be used, not just to eliminate tax on current income, but much more importantly, as a tax-free rebalancing center for the entire household. This is true regardless of whether the qualified accounts use direct indexes.


Watch the webinar recording or read the transcript.

Gerard Michael
Gerard Michael

President, Co-Founder