Direct Indexing in a Changing Environment for Advisors

Direct indexing is the fastest growing segment of the asset management industry. In this interview, Brandon Thomas of Envestnet explains how direct indexing helps clients gain low-cost, tax-efficient exposure to asset classes, ESG and quantitative strategies.

Brandon Thomas is co-founder and co-CIO of Envestnet. He is also managing principal and chief investment officer of the quantitative asset management unit of Envestnet, QRG Capital Management, which was formed 10 years ago. QRG is a GIPS-verified RIA that manages approximately $6 billion in direct-indexing strategies for clients. Brandon is responsible for the firm’s strategy, oversees portfolio management capabilities, and manages the 10-member QRG team.

I spoke with Brandon August 30, 2022.

How have client expectations changed over the past few years in terms of what they're looking for from their advisors, both holistically and more specifically within their investment solutions?

One of the biggest changes overall is that clients are seeking a fully integrated approach to achieving financial wellness. They're not only looking for their advisor to provide a traditional investment solution consisting of an asset allocation comprised of mutual funds or ETFs or separate account managers. They're asking their advisor to provide an end-to-end solution that starts with financial planning, leads to development of a tailored asset allocation, and then incorporates not only the traditional asset classes and investments associated with those asset classes, but also alternative investments, insurance, and structured products. In addition, clients want to integrate banking and access to credit as part of the solution.

They're looking for and can obtain, through Envestnet and other platforms, a holistic approach to achieving financial wellness and not just success in their investment portfolio.

In terms of investment solutions, clients are realizing what academic research has been showing for many years: it is very difficult to outperform the benchmarks over time. Very often the best strategy is to ensure the portfolio has the asset-class exposure that will best help them achieve their investment objectives. Those asset-class exposures can be obtained through very low-cost, direct-index strategies or ETFs. As a result, we and other platforms are beginning to see tremendous growth in the direct-indexing segment.

Given that holistic mandate, how do you and QRG view direct indexing? How is that different from how other advisors have come to know that strategy?

I've never been a big fan of the term "direct indexing." It seems to have popped up over the last three to four years, but I've come to accept it as the label assigned to a segment of investing that's been around for decades. I refer to that as "quantitative investment management."

Quantitative investment management has been around since the 1970s with the advent of the first index funds. Direct indexing refers to constructing portfolios using quantitative approaches and then systematically managing those portfolios to achieve one of several objectives a client may have. One of those objectives could be passively tracking a well-known asset-class benchmark. That's how most advisors and clients think of direct indexing; they want to passively track an index – the S&P 500 or the Russell 1000 – using an optimized subset of positions and not the entire index.

They could also look to track a custom-index design to meet the needs of the client. It could be a blend of indices. It could be a custom-constructed index that the client wants to track that has an objective they want to achieve.

A third goal could be striving to outperform the benchmark through capturing systematic exposures to asset-pricing factors that have shown to produce a risk premium over time, such as value, momentum, and quality. Those are well-known academic factors and direct indexing encompasses factor investing as well.

Another potential goal of direct indexing is to construct portfolios to achieve exposures to companies that have high sustainability or ESG ratings. That's become very popular. There's a lot of debate as to whether those types of companies generate outperformance on their own. But if you can construct a portfolio that tracks an index and achieves those other goals of sustainability and impact, that's a pretty good combination for certain clients.

Finally, a very popular goal is for an advisor to create a completely bespoke solution for their client that can combine dozens and dozens of different dimensions and preferences that could be customized and put together in a unique portfolio that meets the client's objectives. There are a lot of different things that fall under that direct-indexing umbrella. It's not just buying the stocks in an index fully replicating it and managing that portfolio going forward. Direct indexing is a definition that broadly covers many different quantitative investment strategies.

That's the definition of direct indexing that you and QRG embrace, right?

Yes. The asset management industry is gravitating towards that definition as well. Most advisors and investors think of direct indexing as passively tracking an index using individual securities – essentially an optimized portfolio that tracks an index. That's what direct indexing has been known as, but it's expanding to include these other categories, whether it's factor investing, ESG or customized portfolios. The industry now is saying, "Okay, there's a lot of benefit here beyond just tracking an index very closely." In addition to those areas I mentioned, you've got tax management. Of course, that's a very big aspect of what direct indexing offers.

You said earlier that QRG manages Quantitative Portfolios. For which type of client are those best suited?

Quantitative Portfolio (QP) is the brand used for QRG's direct-indexing solutions. Envestnet's clients have had access to them for almost 10 years. We offer direct indexing strategies in four different series: three equity series and a new fixed income series.

On the equity side, one of the three are what we call the "Market Series." Those are pure, passively managed strategies where we're not trying to outperform the index. We're trying to obtain asset-class exposure, whether it's domestic, large-cap, small-cap, international-developed, or emerging markets. We want that asset-class exposure to track an index that represents that asset class very closely. We're not trying to outperform. These market-series strategies are very popular with clients that want a low-cost, asset-class tracking solution.

The second equity series is what we call our "Factor-Enhanced Series." These are quantitatively constructed, systematically managed strategies. But in the Factor-Enhanced series, we're not just trying to track the index; we're trying to outperform it through quantitative exposures to various well-known asset pricing factors that have performed well over time. Academic research has identified a handful of such factors, with value, momentum, quality, and profitability being among the most robust. When a portfolio is tilted toward those types of factors, it is expected to outperform over time – not all the time, but over time.

Our third series is our Sustainable series. We're not trying to outperform the index, but to track it very closely, with tilts toward companies that have high sustainability and ESG ratings. For example, they may have a low carbon footprint. These are very customizable because clients in this area have unique needs and preferences when it comes to sustainable investing, and want to align their values with their investments.

Our fixed income series, which we just launched, includes investment-grade corporate and investment-grade municipal bond ladder strategies. These are laddered portfolios, one to 10 years, very quantitatively constructed, with a very rigorous methodology, and they're designed to provide consistent income for clients and a buffer to rising interest rates.

These are quantitatively constructed and systematically managed strategies, and we have composite track records going back almost nine years for some of them. They are best suited for clients seeking a low-cost strategy implemented methodically and systematically. These are sometimes half the cost of actively managed separate accounts. They appeal to clients seeking a low-cost strategy designed to provide consistent exposure to an asset class like our Market Series, or to outperform an index through consistent exposure to asset pricing factors, or to express their values through a sustainable-type portfolio.

You mentioned earlier that these are tax-efficient strategies. What makes them tax-efficient and how can advisors take advantage of that efficiency?

Tax efficiency is one of the key benefits that's been promoted with direct indexing strategies, and there are a few reasons why QPs specifically and most direct-indexing strategies tend to be excellent vehicles for it. These vehicles are implemented in separate accounts. The client owns the individual tax lots, so tax-loss harvesting and offsetting of gains with losses is very efficient and easy to do within the operational and technology capabilities that we have.

QPs are excellent vehicles to use in tax-transition cases. A lot of the cases we get in taxable accounts are situations where the client has existing positions, and they fund the account in kind. These positions are either a very concentrated number of positions or they're more diversified. The positions typically have a low-cost basis, but the client wants to transition into something that's more diversified in a tax-efficient manner.

Direct indexing is tax efficient because QPs and other direct-indexing strategies hold more positions than a typical separate account. Some of our strategies hold more than 200 positions, and while that seems like a lot, it allows for more opportunities to harvest losses or offset gains with losses. That's difficult to do in a traditional actively managed strategy that may have 40 or 50 positions and you don't have that variety of gains and losses in the portfolio that you can effectively tax-manage.

Those are three of the reasons. Our clients often apply tax-overlay services to our Quantitative Portfolios. The vast majority of our taxable accounts employs some type of tax management. We've got very robust performance reporting that shows the tax alpha from implementing these tax strategies. The tax efficiency and the tax benefits of using direct indexing strategies is real, and it's measurable for clients, which is very important to most taxable clients.

The investing environment we are faced with is characterized by high inflation, rising interest rates, geopolitical risk, and what many perceive are high valuations by historical levels. Are these solutions better suited for advisors and their clients, given that backdrop?

Yes. I've been in the business for almost 40 years. Direct-indexing strategies are all-season vehicles. They're terrific in this type of environment. Sometimes a client just wants to be completely passive, because they know it's always difficult to outperform the index. Since it’s historically proven to be very difficult to outperform the market, our passive-market and sustainable strategies are always useful.

There is an increasing amount of focus on sustainable strategies, and these are also very useful in this, and every, type of market environment. You see more advisors and managers interested in this area, which makes these types of strategies, where a client can gain exposures to an expanding palette of ESG and sustainability dimensions, very useful vehicles.

The Factor-Enhanced strategies are particularly attractive given the environment you just mentioned. Over the last 12 years, we've been in a unique monetary policy environment where there's been quantitative easing and abnormally low interest rates. Now, because of inflation, we're starting to see the Fed normalizing its interest-rate policy. It is also unwinding its balance sheet, so we're getting back to a more historically normal type of monetary policy environment. That makes it very favorable for factors to perform well. Over the last year-and-a-half, factors have done very, very well, and we're doing a lot of research in this area as to what we can expect going forward in terms of factor performance.

We believe that as happened after the tech bubble in 2000 and after the Great Recession in 2009, we're going to see a multi-year tailwind for factor performance, and this environment will lend itself very well to factor-based strategies. QPs and direct indexing are useful for advisors and their clients that have a desire to provide low-cost solutions designed to consistently achieve certain objectives, whether it's asset-class exposure or exposure to sustainable dimensions. It's a philosophical decision by the advisor to provide their clients a low-cost solution and give them the exposures they need. That philosophical decision transcends any type of market environment.

You mentioned that this is a favorable environment for factors to perform well. How should advisors think about factors and which combinations of factors do you think will be most successful?

If you haven't noticed already, I'm a big proponent of factor-based investing. I think of factor investing as occupying the quantitative active-management space within the direct-indexing category. The asset management industry, as well as some advisors and investors, think of direct indexing as a passive strategy, just trying to track an index. But I've included quantitative active management, meaning factor-based investing, within direct indexing. There's many decades of academic research, some of it produced by Nobel Prize winners like Eugene Fama, highlighting the benefits of tilting towards certain factors. So, I believe it's a very good philosophy to adopt in an advisor's practice.

Do factors always perform well? No. We've been through a period over the last year-and-a-half where they have performed well. But for the five years prior to that, factors generally did not perform well. During that time there were a lot of advisors and investors questioning whether investing in factor strategies is worth it. Factors will go through periods of difficult performance, but over time and across all asset classes and markets, one can expect that tilting toward factors will enhance their portfolio returns. Academic research has shown that these factors aren't only adherent to one particular asset class. They're useful across asset classes, whether it's equities, fixed income or commodities, and different markets – U.S. and international.

When you referred to the factors that performed well the last year-and-a-half and didn't perform well the prior five year or so years, was that the value factor?

You're exactly right. Prior to the fourth quarter of 2000, for three or four years, value did extremely poorly. There are many reasons that have been proposed as to why that's the case. Our view is that this abnormal monetary policy environment made the distinction between different types of stocks go away. When the economy is artificially awash in money and interest rates are low, more companies benefit, and distinctions among companies are diluted.

Now, we see this normalization of monetary policy with rising interest rates, and in our view that's going to create a more favorable environment for factor performance as the historical risk-based and behavioral drivers of performance return. Value is a good example. After three or four years of very poor performance, value has performed extremely well over the last year-and-a-half. But in our opinion we’re in the early innings. From a performance standpoint, we seem to be in a period comparable to those following the bursting of the tech bubble in 2000 and the financial crisis in 2009. We believe it’s very possible there's going to be a multi-year tailwind in the performance of value and other factors.

The size factor is the idea that, within a universe of stocks, smaller caps tend to outperform larger caps. Even in the large-cap index universe, the companies on the lower end of that market-cap scale tend to outperform the largest companies over time. The small-cap factor has not performed well for a long period of time, and even this year, it hasn't performed as well as it has historically. But over time, the risk premium of small-cap stocks is going to come back into vogue, and it’s going to perform well.

There are only a handful of factors that academic research has shown to be robust over many different market environments and across markets. Momentum is one of those, and it is the idea that stocks that have performed well over the recent past on a relative basis will continue to perform well for the next short period of time, whether it's three to six months. That's a well-known and robust factor.

Quality is a factor that is a combination of profitability, investment, and volatility. The quality factor has been one that's been very consistent and has performed well over the recent 18 months.

Multifactor portfolios are beneficial because each of these factors on a standalone basis performs well over time. If you just invest in a momentum, value or a quality portfolio, they perform well over time, but when you use them in combination, they perform extremely well on a risk-adjusted basis. There is low or slightly negative correlation between the performance of factors. Value and momentum are negatively correlated, even though individually each of them performs well over time. Quality also has a very low, positive correlation to both value and momentum, and that combines well with those other two. A portfolio that combines value, momentum, and quality, or just value and quality, performs very well.

Let's switch gears. You had mentioned that fixed income was one of the four components of your Quantitative Portfolio offering. You recently launched a laddered bond strategy. How does that work? How does it tie into the trend of personalization?

We recently launched our one-to-10-year investment-grade corporate and municipal laddered portfolios. These work very well within our direct-indexing suite of products because they're quantitatively constructed, designed to provide consistent income over time in high-quality names, and, due to the ladder concept, have a form of immunization against a rising interest rate environment. As bonds mature, the proceeds are reinvested at the long end of the ladder. We're taking advantage of the prevailing interest rates at that time, so the portfolio is designed to keeping up with whatever the interest rate environment is at that time. They work very well in a rising-rate environment such as we are experiencing.

As far as personalization, bond portfolios by nature are customizable for a couple of reasons. Each client has unique objectives. On the municipal side, they may want a portfolio that's state-specific or state-centric, or they may want to implement duration or maturity constraints. The availability of bonds at the time of investment makes these personalized because we could have two clients coming into the same strategy on different days within a week and they may get completely different portfolios depending on their objectives and the availability of bonds. We want to make sure that we're buying bonds at attractive prices, but still meeting the objectives of the strategy.

These laddered portfolios lend themselves well to personalization.

What is the key takeaway for advisors when they consider direct indexing and, specifically, how Envestnet deploys it to help its clients?

Clients are looking for a holistic approach to achieving financial wellness and not just success in their investment portfolio. Direct indexing can help them attain that goal. Our QPs appeal to clients who are seeking a low-cost strategy that provides consistent exposure to an asset class like our Market Series, or are hoping to outperform an index through consistent exposure to asset pricing factors, or to express their values through a sustainable-type portfolio. The tax efficiency and tax benefits of direct indexing strategies are real and measurable, which is a key takeaway for most clients.

Nothing contained in this article is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The information, analysis, and opinions expressed herein are for informational purposes only and represent the views of the authors, not necessarily the views of Envestnet. The views expressed herein reflect the judgement of the authors as of the publication date and are subject to change at any time without notice. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. Past performance is not indicative of future results.

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