Twilight of the ETF? Why Direct Indexing matters

Wealthfront launched its Direct Indexing Platform for retail investors with some fanfare back in 2013. For those unfamiliar with the concept, direct indexing allows the investor to replicate the performance of the broader market while capturing the tax advantages of owning individual securities. These advantages can be considerable: the Silicon Valley firm estimates that on its flagship Wealthfront 1000 product (which blends up to 1000 stocks from the S&P 1500® with a small cap ETF) it can generate more than 2% in additional returns in tax savings per year. With investor entrance requirements at a million dollars, that’s a lot of dough. Wealthfront describes its indexing platform (soon to be available in modified form for as little as $100,000) as taking “passive investing to a whole new level.” A bold claim, perhaps, but one that does not seem unfounded. Over the last decade, the ETF has taken market share from the more expensive and less wieldy mutual fund. Why wouldn’t the hyper tax efficient direct indexing method gain purchase at the expense of the ETF, particularly as costs to the investor trend lower? Time will tell, but it’s worth noting that Wealthfront isn’t the only firm that wants to outindex Vanguard and other professional indexers. Competition is coming from an unexpected place: Cambridge, MA based Smartleaf, Inc. The provider of tax overlay software to bank trust departments and RIAs is making a quiet pivot towards the asset management business. The new entity known as Smartleaf Asset Management wants to use its proprietary rebalancing technology to solve what CEO Jerry Michael calls the “optics problem” of paying an advisor to run a low cost passive strategy. Michael says his technology will help him stand out in two ways. First, he can customize portfolios to the social investing or other preferences of the investor. Second, he can transition existing investor holdings directly into the new indexed portfolio, an appealing feature for investors holding low basis stock. Unlike Wealthfront, Smartleaf will not be marketing to the consumer directly, but rather serving as a sub advisor to retail brokers and other distributors. This doesn’t mean Smartleaf and Wealthfront won’t eventually meet on the playing field. Michael says investors will be able to access what he calls his Indexing 2.0 platform for as little as $50,000, since he deploys a portfolio limited to 35 or 70 stocks. While the platform isn’t yet live, it is slated to appear on a major online brokerage platform by the end of the month. Disruption is an overused word, and the big trends don’t come around that often. I believe we are seeing such a trend in the form of Direct Indexing, with implications for the ETF and the firms behind them. Expect the doors to open to all levels of investors as more and more firms jump on the Direct Indexing bandwagon.