Wealth Management
About 14% of advisors are aware of and recommend direct indexing solutions to their clients which is the primary reason that its forecast to grow faster than ETFs over the next decade. In a recent article by Allen Roth of WealthLogic, he discusses the pros and cons of direct indexing and compares it to ETFs.
Direct indexing has many of the same characteristics as ETFs such as allowing exposure to broad categories and having low costs. However, it allows for greater customization that can allow for portfolios that are more tailored to a client’s needs.
Another distinct advantage of direct indexing are that it allows for tax-loss harvesting which can offset capital gains. This strategy can allow for an additional 0.2 to 1% of returns and is more beneficial in down years.
In terms of disadvantages, many of the most popular ETFs have less costs than direct indexing. For example, the most popular S&P 500 ETFs have annual expenses of 0.03%, while most direct indexing fees are in the 0.4% range.
While this won’t make a different in the near-term, it will matter in the long-term especially as tax-loss harvesting benefits erode over time. Additionally, the slight tax benefits may be outweighed by the tax complications as each trade needs to be accounted for.
Finsum: Direct indexing is expected to grow at a faster rate than ETFs over the next decade. Yet for many investors, ETF remain the better choice.
After a decade of low rates and abundant central bank liquidity, market conditions are going to be much more challenging over the next decade. According to Jason Xavier, Head of EMEA ETF Capital Markets at Franklin Templeton, these developments mean that a major opportunity is brewing for active fixed income ETFs. He discussed this in a post for Franklin Templeton’s Beyond Bulls & Bears publication.
While most fixed income ETFs are passive, the active category is exploding in response to the need of investors to express various views. In contrast to passive strategies, active ETFs utilize fundamental analysis and have greater discretions on which instruments they can select rather than be limited by an index. Active managers have greater flexibility to respond to a change in market conditions or external catalysts unlike passive managers.
In the fixed income space, the ETF structure leads to increased price transparency and liquidity especially compared to traditional bond markets which are typically quite opaque. ETFs also give smaller investors access to fixed income opportunities which were typically only available to high net worth investors or institutions.
In sum, Xavier believes active fixed income ETFs will continue to see growth as they are likely to outperform in more volatile conditions and will lead to increased transparency and liquidity in the fixed income market.
Finsum: Franklin Templeton’s Jason Xavier sees the active fixed income ETF category continuing to rapidly grow as it offers major benefits to investors.
A recent article from Morningstar’s John Rekenthaler discussed the tax benefits of direct indexing. Direct indexing is a strategy that involves directly buying the stocks of an index rather than through a fund.
This confers several benefits such as allowing investors to gain the benefits of indexing while still being able to customize their portfolio to reflect their values and better fit their needs. Due to this, the category has exploded and gone from a niche offering solely for high net-worth investors to being offered by retail brokerages to customers for as little as $5,000.
However, the strategy is not necessarily for everyone, but it can be particularly useful for those with sizeable assets due to the potential tax benefits. This is because direct indexing results in capital losses in a separate account when stocks drop below their cost bases. The proceeds are then re-invested in stocks with similar profiles.
This strategy can be particularly useful for investors with high federal and state taxes, large amounts of money invested in direct indexing vs other investments, short-term capital gains, and dealing with a volatile market environment.
FinSum: Direct indexing comes with several benefits for clients but the most substantial one is the tax savings. However, it’s only worthwhile for a particular group of investors.
More...
According to Daniil Shapiro of Cerulli Associates, there is a major product development opportunity for active fixed income ETFs in the coming years. A variety of factors are behind this segment’s growing popularity including the increasing acceptance of the ETF structure, growth of advisors who are comfortable with fixed income ETFs, and rising rates which lead to increased structural demand for fixed income products.
The report was compiled by Cerulli Associates based on polling of financial advisors and was covered by Kathie O’Donnel in an article on Pensions & Investment.
The major takeaway is that use of fixed income ETFs by advisors is rapidly growing with 70% reporting use in 2022, up from 63% in 2021. Most ETF issuers pointed to greater advisor acceptance of the product and institutional demand as drivers of the ETF market. Among issuers, 66% see fixed income as their primary focus which exceeded equities at 57%.
Overall, this survey reveals that there continues to be opportunity for ETF issuers in the active fixed income space, given rising demand. While there are plenty of options in passive fixed income, there are relatively less active options.
Finsum: The fixed income ETF category is rapidly expanding. Within the space, passive is saturated but plenty of opportunity remain for active managers especially given expectations of rising demand in the coming years.
According to an article by Todd Rosenblum of ETFTrends, a survey of financial advisors revealed that 68% of financial advisors gain fixed income exposure for clients through bond mutual funds, followed by bond ETFs at 61% and individual bonds at 58%.
Yet, the category continues to grow at an impressive rate with about $45 billion of inflows into US-listed bond ETFs. In total, bond ETFs have $1.3 trillion in assets which comprises 20% of the overall base, indicating more room for growth.
Some of the major advantages of bond funds such as ETFs or mutual funds are increased diversification and opportunities to enhance returns which can’t be found when buying individual bonds.
Bond funds can even be bought with a specific maturity date when your client may have a need for liquidity. It also avoids the risk of a credit downgrade or default which is elevated in an individual security. Another is that bond ETFs are much more liquid and with tighter spreads than individual bonds. Additionally, many of the most liquid and popular fixed income ETFs invest in hundreds of bonds issued by high-quality companies.
Finsum: Fixed income ETFs are a fast growing category but still trail behind fixed income mutual funds in terms of popularity with advisors. However, it does offer major benefits compared to investing in individual bonds.
Regulators are looking to get more aggressive about enforcement of Regulation Best Interest (Reg BI) which was passed in 2020. Regulators are particularly focused on sales practices to ensure that fiduciary standards are followed according to a Thomson Reuters article by Richard Satran.
Reg BI mandates that recommendations are offered with impartial advice and explanation of alternatives, including to competing firms. Along with the SEC, Reg BI has also been adopted by the Financial Industry Regulatory Authority (FINRA).
One challenge for firms and regulators is that automated monitoring of transactions to ensure compliance is lacking. According to Parham Nasseri, VP in product and regulatory strategy at compliance software developer InvestorCOM, Inc: “Putting the risk assessments into a surveillance system for Reg BI compliance involves significantly more challenges than the kind of monitoring that systems have done in the past.”
New elements to monitor include conflicts of interest, customer profiles, costs, alternative investments, and other client-specific factors. Along with the technological challenges, firms will have to comply with new exam requirements to comply with new sales practice rules.
Finsum: Reg BI was passed in 2020 but regulators were slow to begin aggressive enforcement given the pandemic. This is changing and firms will be forced to rapidly update sales practices, training, and monitoring.