By Jamie Catherwood is an Associate at O'Shaughnessy Asset Management, and Founder of Investor Amnesia.
Humans don’t like change. We love innovation, but not change. This seemingly irrational paradox stems from a powerful concept in psychology: inertia.
“Inertia is the tendency of consumers to adhere to their existing habits or actions even when presented with a superior alternative.”1
Although we often inevitably switch to the better alternative, we initially search for reasons to avoid changing the status quo. Some of history’s greatest innovations were originally ridiculed and resisted:
The finance industry is no exception. There is roughly $11 trillion invested in U.S. equity index funds today, but when they first launched, index funds were deemed “un-American”.2
Exchange-traded funds (ETFs) faced a similar reception when they first launched in the 1990s. Despite their advantages over costlier and less tax efficient mutual funds, investors resisted this new product challenging the status quo. Of course, we now know that investors ultimately recognized the merits of ETFs over mutual funds, and the asset flows for each vehicle have reflected that shift in sentiment.
In many cases, technology is the antidote for inertia as it solves the problems creating inertia. This was true for ETFs, which benefitted from advances in telecommunications technology during the 1990s as transmitting data and stock prices became cheaper. Then, a combination of the internet and cheaper technology facilitated the rise of online brokerage firms allowing retail investors to buy ETFs.
Today we are on the precipice of another technology-led evolution in asset management: a transition from the commodification represented by mass-market ETFs to the personalization possible with Custom Indexing.
THE CUSTOM INDEX
The innovation of ETFs was leveraging technology to bundle a diversified basket of stocks into a low-cost, liquid and exchange-traded vehicle. Today, the Custom Index leverages new technology and developments like commission-free trading to unbundle pre-packaged funds (ETFs) into a truly personalized, inexpensive, tax efficient vehicle.
Custom Indexes are implemented through a separately managed account (SMA) where investors directly own a mix of individual securities instead of indirectly owning positions through shares of funds and ETFs.
Owning individual securities in a Custom Index enables more precise execution of high-end financial planning and benefits not available to ETFs, particularly in tax loss harvesting, ESG & SRI, concentrated stock risk management, transitioning of securities, and Customization.
DIMENSIONS OF COMPARISON
Proponents of ETFs could argue “if it ain’t broke, don’t fix it.” ETFs certainly remain a fantastic way to invest and are a great option for many investors. However, just because your Motorola Razr still works, it doesn’t mean you shouldn’t get an iPhone.
Still, as with any product challenging the status quo, the onus is on Custom Index providers to demonstrate their advantage over ETFs. This article focuses on how Custom Indexing can surpass ETFs in each of the broad categories we feel advisors value most: Cost, Taxes, Scalability, and Customization.
COST
Arguably the most defining feature of ETFs is their low cost. With expense ratios on some passive ETFs falling below 0.05%, ETFs have a seemingly clear advantage over Custom Indexes. The truth, however, is more nuanced.
"Cheap" can be Expensive
ETFs are powerful in simplicity, but their low cost reflects that simplicity. If “you pay for what you get”, ETFs give you “cheap, simple, and reliable”. This is not a sleight against ETFs but it is relevant because of their hidden costs.
The issue with ETFs and commingled funds is that their structure prevents advisors from accessing other tools to better serve clients. Before discussing these tools, however, we should acknowledge the apples-oranges comparison many make when comparing the costs of ETFs to other vehicles. People often use passive low-cost US Large Cap funds priced at 0.03% as the benchmark as if this fee applies to all ETFs. This ignores the reality that advisors use a blend of active and passive funds across a range of investment universes that are substantially higher than 0.03%.
Unfortunately, there is no clean data set available on advisors’ most common ETF allocations and their associated expense ratios. However, one of the differentiating features of Canvas (OSAM’s Custom Indexing platform) is its “Transition Tool”, which allows advisors to construct a “road map” for transitioning clients’ existing portfolios onto Canvas.
Since the portfolios uploaded are managed by advisors pre-Canvas, we analyzed this data as a proxy for the allocations and funds commonly used by advisors. As expected, the weighted ETF allocation fees were more representative of the true fees paid on an entire allocation of ETFs, as opposed to the fee on one passive US Large Cap ETF.
As we alluded to, ETFs have hidden costs not included in expense ratios: the capabilities you cannot access.
Viewed through this lens, the true cost of ETFs feels more expensive. The beauty of a Custom Index is that advisors can recreate their existing portfolio exposures for a comparable fee, and access powerful capabilities unavailable in ETFs at no additional cost. For example, using a Custom Indexing platform, an advisor can establish customized annual tax budgets for each one of their clients.
Canvas has a 0.20% minimum fee for accounts over $1 Million, but no added costs for the platform’s many features. Clients are not charged for beta exposure, and the management fee is simply based on factor and region exposures. A $1.5 million portfolio with 100% passive beta exposure would be charged 0.20% for use of the platform, and all capabilities offered in Canvas.
Advisors are effectively paying the same fee as a Custom Index for an ETF allocation that cannot execute opportunistic loss harvesting, create client-specific tax budgets, customize for every client’s unique preference at scale, or account for concentrated stock risk.
TAXES
Exchange-traded funds have gained popularity with advisors and investors because they are more tax efficient than their predecessors: mutual funds. Specifically, this advantage stems from ETFs not distributing capital gains to investors. However, an investment vehicle’s tax efficiency should be measured on an absolute basis, not relative. In other words, we all agree that ETFs are more tax efficient than mutual funds, but does that mean they are “best-in-class”?
For all their proficiencies, ETFs remain deficient in key areas. The main issue with ETFs is rooted in their commingled structure, which leaves no room for sophisticated tax management and loss harvesting on individual-securities. So, while they don’t pass through capital gains distributions, they do prohibit investors from receiving the full benefits of tax loss harvesting.
For example, since 1990, 36% of companies in the Russell 1000 Index have negative returns in a given year. Importantly, this occurs when the index has a positive or negative annual return. For example, in 2020 the Russell 1000 Index returned 20.96%, but 39% of companies in the index had negative returns.
Since they only owned shares of the ETF (not its underlying holdings), investors in a Russell 1000 ETF could not harvest any losses. Selling shares of the ETF would trigger capital gains taxes because the 2020 return was positive.
Alternatively, a Custom Index replicating that passive exposure could harvest losses on the 39% of stocks with negative returns. These losses can help offset the client’s tax bill from capital gains.
The fully passive Custom Index below offers a good example.3 By opportunistically harvesting losses throughout the year, the account maintained a similar return and risk profile to the Russell 3000 while generating +77 bps of tax alpha unattainable through comparable ETFs.
So, yes, ETFs are more tax efficient than mutual funds, but this is the wrong benchmark. As new technology makes tax management easier and more effective in other vehicles, advisors should focus on what ETFs cannot do:
- Tax loss harvesting at the individual lot level.
- Opportunistically harvest losses throughout the year at the lot level to take advantage of unique opportunities (like COVID in March 2020) that fall outside traditional year-end harvesting.
- Customize each client’s individual tax parameters by setting annual tax budgets.
ETFs bar investors from the benefits of more sophisticated tax management capabilities and the ability to customize each client’s tax guidelines.
SCALABILITY & CUSTOMIZATION
From a business perspective, ETFs are popular with advisors because of their easy implementation and scalability. However, there is a misconception that managing a suite of model ETF/Mutual Fund portfolios is more scalable than a separately managed account Custom Index. This is understandable, as the thought of every client having a personalized portfolio conjures images of chaotic spreadsheets and treating every client’s portfolio individually. In other words, the opposite of scalable.
We offer two counterpoints:
- From our conversations with advisors, the scalability of ETF and mutual fund models seems to be exaggerated. Many firms we’ve talked to complained how time consuming it was to trade and manage their model ETF/mutual fund portfolios, which took valuable time away from interacting with clients.
- Custom Indexing is innovative because it offers deep customization without sacrificing scalability. This is enabled by a platform approach that centralizes key portfolio management functionalities in one place. Model portfolio creation and customization on one platform. “Mass customization”.
Mass Customization
The model portfolio construction process can be viewed as two phases: Setting the Allocation (Building Model Portfolios) and Customization. Both ETFs and Custom Indexes offer Phase 1, but only Custom Indexes can offer the customization in Phase 2.
As shown, only Custom Indexes can offer the second phase: unique customization at scale. For asset managers with a long history of running SMA strategies and leveraging technology, account-specific customizations are nothing new. Each customization built on top of an underlying model is just a change to the “ruleset” programmatically managing and trading each account. This automated process enables mass customization at scale with just a few clicks.
Managing Transition Costs and Tax Impact
Understandably, advisors considering Custom Indexing over model ETF portfolios may have concerns over logistical issues like the tax costs of transitioning incumbent portfolios to a Custom Index. As a technology enabled platform, Canvas offers (as should Custom Indexing peers) a dynamic and customizable tool for transitioning incumbent portfolios in a manner that satisfies the advisor and end client.
Advisors can upload an existing holdings file and design a tax-managed road map for realizing and transitioning embedded gains. This tool includes the ability to set a customized tax budget for transitioning the client’s portfolio that allows advisors and their clients to view the tax cost, proximity to target model, and improvement in characteristics associated with their transition choices.
MANAGING CONCENTRATED RISK
The final dimension of comparison is a problem that our firm only truly appreciated after working with the advisors at our Canvas partner firms: managing concentrated stock risk. This generally occurs when a client is an early employee or executive at a company and has much of their net worth tied to company stock held at a very low-cost basis.
Advisors explained the difficulties of managing clients’ concentrated exposures alongside ETFs and mutual funds. Typically they spoke of liquidating a quarter of the postion each year over four years – agnostic of market and risk. Concentrated stock scenarios present many issues for both the client and advisor:
- Clients often have these concentrated exposures in their employer’s stock, meaning the client has significant investment risk and human capital risk tied to one company.
- Compared to the broader market, the average single stock generates lower returns and higher volatility. Having the majority of a client’s portfolio tied to one stock carries serious risk.
- Concentrated positions often have a low cost basis. This further complicates the issue, since reducing the position size by selling shares produces a sizable tax bill (from capital gains).
- Even when advisors recognize the risk of a concentrated position they cannot avoid increasing this exposure via passive ETFs. For example, if the client had 45% of their net worth in Apple, most U.S. equity indexed ETFs have Apple in their Top 10 Holdings.
- There is consensus that daily tax management is optimal but incredibly burdensome when done manually.
These issues highlight the challenge advisors face in managing concentrated positions overall, let alone with ETFs. Although each concentrated stock scenario is unique to one individual and one company, ETFs are structured to treat every investor the same. This mismatch creates headaches for the advisor and client. The answer is customization.
Custom Indexing produces innovative solutions for such challenging problems because it pairs the dynamism of owning individual securities in a separately managed account with sophisticated software and technology. Using this powerful combination to manage concentrated risk exposures, advisors using Canvas can:
- Build tailored portfolios that optimize around the concentrated risk by underweighting and/or excluding the concentrated stock itself, and “nearest neighbor” stocks with similar risk exposures.
- Leverage the power of tax loss harvesting to efficiently work down names by offsetting any capital gains with losses generated elsewhere in the Custom Index. In other words, use losses harvested on the 36% of stocks that lose annually to offset the taxes on capital gains generated by selling shares of the concentrated stock.
The following example represents a real-life Canvas portfolio where an advisor’s client started with a 45% weight to Accenture. The client’s advisor was eager to transition to a more diversified portfolio, but the position was owned at $0 cost basis.
Through active tax management (% of position sold each day labeled on the curve) the position was reduced to 14% in 8 months with zero net capital gains. This led the advisor to liquidate the position in August to fully achieve the target diversified model at a fraction of the cost and risk exposure.
Of course, it is important to note that this occurred within the context of COVID-19, when markets cratered in the first half of 2020. However, regardless of market environment, technology enabled tax management greatly increases efficiency, improving tax outcomes.
For advisors, this example probably brings a few clients or prospects with similar situations to mind. Previously, advisors were left with little recourse for managing these positions as ETFs and mutual funds simply cannot offer the level of customization and dynamism required for working down the exposure of one stock. Custom Indexing now solves this problem in a matter of clicks.
CONCLUSION
Advisors should be excited. Whether you were an early embracer or late adopter of ETFs, Custom Indexing offers another rare opportunity to challenge the status quo and deliver value to clients.
In every other facet of life we crave personalization over commodification. Choosing between a tailored dress/suit and mass-produced off-the-rack option, most prefer the tailored – especially when priced equally. Investing will be no different.
ETFs lock advisors and their clients into the same positions as every other investor holding the same ETF, regardless of risk profile, income, time horizon, etc. It is inevitable that clients will demand to be treated as the unique individuals that they are, and Custom Indexing enables you to meet this need.
There is a reason that industry giants are acquiring companies that specialize in Custom Indexing / Direct Indexing. Even the world’s largest ETF provider, BlackRock, is preparing for this future by acquiring a Direct Indexing provider. In the past, personalized investing was restricted to wealthy clients with large accounts. However, technology and commission-free trading have brought this offering to the masses.
Looking five to ten years into the future, do you think more clients will own personalized or pre-packaged portfolios? If it is the former, we’d love to speak with you further about Custom Indexing.
FOOTNOTES
1 Himanshu Seth, Shalini Talwar, Anuj Bhatia, Akanksha Saxena, Amandeep Dhir, ‘Consumer Resistance and Inertia of Retail Investors: Development of the Resistance Adoption Inertia’, Journal of Retailing & Consumer Services (Vol. 55, 2020)
2 https://www.pionline.com/special-report-index-managers/passive-assets-rise-359-2087-trillion-strong-returns (As of June 30,2021)
3 This example account has an 85% passive allocation to US Large Cap, and 15% passive allocation to US Small-Mid Cap.
All posts are the opinion of the contributing author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CAIA Association or the author’s employer.
About the Author:
Jamie Catherwood is an Associate at O'Shaughnessy Asset Management, and Founder of Investor Amnesia.
He publishes a weekly financial history newsletter to +14,000 subscribers and offers courses on the history of markets. His work has been featured in the Wall Street Journal, Financial Times, Bloomberg, New York Magazine and more. Jamie has given presentations and talks on financial history at Yale University’s School of Management, BloombergTV, and industry conferences across the country.