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With the action at Motif, Folio and Parametric as exhibits, RIAs may be on the verge of buying investments more like Spotify music, less like CDs

Schwab and Goldman Sachs made direct-indexing purchases and Parametric wildly raked in direct-indexing assets. Added to zero commissions, an ESG revolution and better software, RIAs may be able to cheaply and effectively become smart-beta indexers

Author Josh Levin, Guest Columnist June 22, 2020 at 8:01 PM
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Josh Levin: 'I have bet my career on direct indexing as the paradigm-shift-to-end-all in the world of investing.'


Kristopher Heck

Kristopher Heck

June 22, 2020 — 10:12 PM
Setting aside the cost of SMA managers vs. ETF expense ratios, there are still a few challenges with Direct Indexing: 1) Trading spreads of the underlying positions - average S&P 500 constituent spread is ~5 bps, but a large ETF manager can cross, dark pool, or just plain create/redeem their rebalances, and all their creation/redemptions are in-kind (no spread cost), so the large ETF manager is lower on ongoing portfolio t-costs, even with "free trading". Same logic holds true for other equity indices - t-costs will be higher for direct retail participation versus BLK, Vanguard, SSgA, etc. The TER savings will only overcome this for high cost ETFs, like sector/niche domestic US equity asset classes. 2) Payment for order flow - if Schwab, TDA, Robinhood, etc. are selling retail order flow for 2-3 bps, does the retail client pay for it somehow...? 3) Non-US equity indices, around 45% of the global stock market - ADRs are missing about 1/3rd of non-US equities, so 15% of the global stock market is not eligible for direct indexing at US discount brokerages with "free" trading. What is the size of the tracking error if you exclude 1/3rd of eligible securities from consideration? 4) RIA-managed Direct Indexing needs to consider how to monitor corporate actions and constant dividend reinvestment. The SMA managers would of course already have this built in to their processes. I would not say there are no benefits to Direct Indexing, or Index SMAs, but they are not the panacea they are made out to be. Completion strategies come to mind as a useful way to deploy them.
Brian Murphy

Brian Murphy

June 22, 2020 — 11:39 PM
I just don't see the client asking for anything resembling direct indexing. They want to meet specific goals in the easiest way possible. Holding 100 stocks in fractional shares and then reconciling transactions for tax purposes at the end of the year sounds like a nightmare to me. Maybe Josh is right, and I'm missing something, but I just don't see how movements like BLM, or Covid or anything else raised in this article are going to push consumers towards direct indexing. Color me skeptical.

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