September 15, 2022

    ETF Insider

    Welcome to this week’s ETF Insider.

    If you’ve been hearing more about direct indexing but not sure if it makes sense for your clients and your practice, you’re not alone. Providers of direct indexing services – particularly those that also offer off-the-shelf index ETFs – are starting to provide some help determining when customized separately managed accounts make sense for clients, and when they don’t. We’ll dig into Vanguard’s most recent direct indexing guidelines for advisors.

    We’ll also look at a new report from State Street Global Advisors that shows rising concern about inflation and volatility, and a desire for advice about how to work through those portfolio challenges. Advisors aren’t just lending a calming voice, however; they’re making moves. Sales data shows that advisors are steering clients into new sources of income, ike options overlay strategies, and more inflation-resistant areas of the bond, equity and commodities markets.

    Thank you for spending a few moments of your day reading this newsletter. Feel free to reach out anytime with questions or feedback:

    Jackie Noblett, producer of ETF Insider at Financial Advisor IQ

    Rules of the Road for Direct Indexing

    Managers that provide the technology and services for direct indexing have been vocal about its benefits. They have been less direct, generally, in helping advisors understand where it works best – and where it may not be worth the cost and complexity.

    But as more big asset managers jump into the direct indexing business, that’s begun to change in an effort to differentiate the service from their index ETFs and other cheaper, off-the-shelf options. Most recently, Vanguard has begun circulating a rough outline of the types of accounts that are good candidates for the service. Charles Schwab, for its part, has laid out a series of questions to help advisors profile the kind of client that could benefit from custom SMAs.

    Despite growing financial media buzz about direct indexing, adoption remains low: just 12% among the advisors that Cerulli Associates surveyed late last year for a report commissioned by Parametric Portfolio Associates. Seattle-based Parametric, which is now mart of Morgan Stanley Investment Management, is the largest provider of direct indexing SMAs.

    Awareness was one reason for the low figures; less than half of the survey respondents understood what direct indexing was.

    Click on the image to get a brief refresher on the mechanics of direct indexing.

    Among those who knew about direct indexing, but didn’t use it, the main barrier to adoption appears to me a lack of motivation: 59% said they were satisfied with their current investment options.

    Indeed, advisors across channels have been moving toward ETFs that provide some of the tax and cost benefits. After all, few equity ETFs pass off capital gains distributions, and the products can be used for year-end tax-loss harvesting of individual stock or active mutual fund holdings.

    Direct indexing can amp up the tax-loss harvesting benefits by picking and choosing which individual stocks within an index to sell. But figuring out how big a benefit that can bring to a particular portfolio, relative to the effort of selling the concept to clients, may seem daunting.

    Vanguard breaks it down for advisors with some easy-to-evaluate benchmarks, starting with a seemingly intuitive one: the client should be facing realized capital gains, and be using an account from which taxes on those gains must be paid (which all but eliminates from eligibility IRAs and workplace retirement plans, for example).

    Ideal targets are portfolios that regularly throw off realized capital gains of at least 3% to 4% of a client’s taxable equity holdings each year, according to an August article from the Malvern, Pennsylvania-based fund giant. In addition, clients should have at least 20% to 30% of their financial wealth in taxable equities to be considered direct indexing candidates.

    “For lower-net-worth investors, the tax efficiency of personalized indexing may not outweigh the additional cost and complexity,” the article notes.

    Schwab similarly lays out attributes for clients that tend to benefit from the “tax alpha” direct indexing can provide, compared to traditional ETFs: those in higher income-tax rates, who benefit more from marginal tax savings; those living in high-tax states like California or New York; and investors who have a long-term buy-and-hold investment strategy for “a sizable portion of their assets.”

    These guidelines highlight the relatively-tailored opportunity set for direct indexing – even if fractional trading and lower minimums make it possible for use in smaller accounts.

    Clients’ Inflation Fears Driving Sales of Derivative-Based ETFs

    Inflation and market volatility have served as a stark reminder of the value of financial advice, new research shows. And sales data suggest that advisors are trying to allay client fears by putting them in ETFs that aim to provide steady income streams while mitigating downside risk.

    Among roughly 120 adults with at least $250,000 in investable assets and who work with an advisor surveyed by State Street Global Advisors this summer, about three-quarters reported discussing inflation with their advisor.

    Investors are also growing more concerned about market volatility, with only 31% of the 242 investors (advised or do-it-yourself) participating in the survey saying they are comfortable with the highs and lows of the market. That’s down from 51% of respondents to the same question a year ago.

    All of this is helping advised investors see the importance of advice, with roughly 90% saying they value their advisor’s guidance even more during market uncertainty. Eighty-six percent say their advisor helps them stay confident amid rising inflation, State Street’s survey found.

    Advisors looking to help clients better stomach the volatility or to find income streams that keep up with inflation have turned to ETFs. But it’s not necessarily the old standbys used in past cycles to fight rising prices.

    Treasury inflation-protected securities, or TIPS, are among the more straightforward inflation-fighting tools, since their rates rise with inflation. But TIPS ETFs have been in outflows this year, to the tune of $1.6 billion year-to-date through August.

    Gold, another tried-and-true antidote, started off the year strong, but has seen investors flee the past two months: the SPDR Gold Shares has shed $3.8 billion since June 30, and the iShares Gold Trust is down $763 million.

    Instead, it money appears to be going into products that focus on alternatives to fixed income, like dividends and options writing strategies, or to products that aim to offer some protection from downside risk and volatility.

    So-called derivative income strategies, including buy-write or covered-call strategies, seek to generate income on top whatever returns of an underlying index might offer. The product aim to do so by selling or buying options on the underlying securities to generate income from the premiums and putting down price floors for trades to mitigate risk of losses.

    These products have amassed $14 billion in the first eight months of the year, making it a top-10 best-selling Morningstar category, according to the Chicago-based fund tracker. Assets in these strategies has grown from $10 billion as of August 2021 to $26 billion one year later.

    Options-trading strategies, including defined-outcome or managed-volatility ETFs, likewise have seen strong sales as investors use options to place guardrails on the amount of risk they are willing to take with a particular index. By sacrificing some upside potential, investors can buffer against portfolio losses. Such products have taken in $6.8 billion year-to-date through August, according to Morningstar Direct.

    Graham Day of Innovator ETFs explains the case for managing risk with defined-outcome ETFs.

    These complex trading strategies have attracted significant buzz – and plenty of new product launches. Still, little compares with the moves advisors and investors are taking to protect against inflation and navigate the Federal Reserve’s sharply higher interest rates.

    Ultrashort bond funds, which invest in fixed-income securities that fall just outside of what a money market fund might invest in, have amassed $31.1 billion. That haul makes such strategies part of the best-selling fixed income category this year, according to Morningstar Direct data. Ultra-safe government bonds also have gotten love: $27.3 billion has flowed into long government bond ETFs, $18.3 billion into intermediate government ETFs and $7.9 billion into short government strategies.