Dynamic Custom Indices: Drivers, Constraints, and Tipping ... · stock selection, portfolio management, and client interactions are all conducted by people, SMAs are only economically

®

The Post-Fund Paradigm Shift

Dynamic Custom Indices:

Drivers, Constraints, and

Tipping Points

The Post-Fund Paradigm Shift

Dynamic Custom Indices: Drivers,

Constraints, and Tipping Points

Transaction Costs and Price Pressure Push Funds toward Passive Investing

Increasing Demand for Personalization

Increasing Demand for ESG Investments and Corporate Data

Investment Management is Ripe for Disruption

Back to the Future: Trading Individual Securities

Ripple Effects: DCIs and Smart Tax Management

The Limitations of DCIs

Approaching the Tipping Point

Market Forces Pushing Asset Managers Downstream

Increased Competition between Asset Managers and Financial Advisers

The Future Starts Now

I. Industry trends challenging the fund-based paradigm

Executive Summary 3

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21

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II. The Post-Fund Paradigm

3

Industry trends

challenging the fund-

based paradigm

Executive Summary

Dynamic custom indices (DCIs) are on the rise, with large implications for the

investment management industry. These diversified investment portfolios,

comprised of individual securities and managed by software, dynamically

rebalance portfolio allocations to reflect client-specific factors.

The rise of DCIs coincides with several demand-side trends, including:

Tumbling fees and costs, competitive trends, and the increasing availability

of both DCI technology and ESG (environmental, social and corporate

governance) data are expected to lead to structural changes in the investment

industry. Given these changes, DCIs are well-suited to become the norm in

public equities investing, leading to new opportunities and imperatives for the

wealth management industry.

Customer pressure on investment managers to decrease advisory

and management fees.

Massive fund flows from active to passive strategies.

A need for investment managers and intermediaries to differentiate,

especially in the wake of recent growth in passive ETF strategies

and consumer-facing technology solutions.

Growing consumer interest in personalized investment products,

particularly from clients who have a strong interest in aligning their

investments with their values

I.

Industry Trends Challenging the

Fund-based Paradigm

®

5

Industry trends


based paradigm

Transaction Costs and Price

Pressure Push Funds toward Passive

Investing

Consumer transaction costs have decreased over time, and this trend is

expected to continue.

When mutual funds and ETFs were first created, they offered individual

investors significant savings on transaction costs, as consumers were able to

create diversified portfolios without the tremendous cost and complexity of

buying each security individually. This decrease in cost played a significant role

in their mass adoption by individual consumers.

In recent years, fund fees have declined significantly, in part accelerated by

the tremendous fund flows from active to passively managed funds. Overhead

and management fees have fallen as technology automates work previously

done by analysts, traders, and portfolio managers. While John Bogle was widely

criticized1 when Vanguard’s first index fund collected only $11 million at first

underwriting in 1976, the assets in passive equity funds now match those in

active equity funds. Additionally, clients have increasingly accepted the use of

algorithms for asset allocation, driving down the cost of fund management.

As the asset management industry noticed the acceleration of assets flowing

into passively managed products, more and more passive funds were launched,

turning index funds into a commodity. This has applied tremendous price

pressure on investment products, especially on traditional, actively managed

mutual funds. In 2018, Fidelity introduced zero-fee funds, cementing a

fundamental change in the business model of investing: revenue is no longer

based on assets under management.

1 https://www.businessinsider.com/vanguard-jack-bogle-first-index-fund-criticism-2019-1

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Increasing Demand for

Personalization

The competitive landscape for financial advisers is much broader and more

varied than ever before. Robo-advisers promise market performance for

fees that are often half of what an independent adviser charges. Digital-first

investment advisers are capturing the attention and assets of investors earlier

in their financial lives. Clients are increasingly aware of the option to bypass

their adviser and buy funds directly. The communications revolution has also

widened advisers’ traditionally local markets, since advisers can now provide

services to practically any geographic location. These elements combine to

pressure advisers to justify their fee structure against more economical options,

and the emergence of fee-only practices3 is no coincidence.

0

2000 2005 2010 2015

0.25

0.50

0.75

1.00

1.25%

Exhibit 1

Asset-Weighted Average Fees for Funds Decline 8% in 2017

Graph sourced from

Morningstar.com2

Active All Funds Passive

2 https://www.morningstar.com/blog/2018/05/11/fund-fee-study.html3 https://www.wealthmanagement.com/industry/advisors-use-fixed-planning-fees-rise

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Industry trends


based paradigm

Additionally, wealth managers and wealth management platforms are

threatened by their own vendors. As fund managers consolidate, with low-fee

ETF offerings, advisers are no longer receiving incentive payments such as

12(b)-1 fees for selling the fund managers’ investment products. Yet, they are

forced to carry these products because clients have learned to ask for low-fee

solutions. Applying even more pressure, many wealth managers are at risk of

their clients bypassing them to buy the ETFs directly.

These changes are forcing investment advisers to compete more aggressively

for new business. While many still lean heavily on client and professional

referrals to build their book of business, they must now earn the privilege of

working with clients who are more aware of their alternatives. Some advisers

have responded by serving a more specific clientele, adopting more technology

solutions, or merging with other firms to manage fixed costs. Changes in the

financial advice market reflect these pressures, with unprecedented levels of

consolidation in recent years and a dramatic growth in industry spending on

technology4.

The proliferation of low-cost, mass-produced investment approaches coincides

with an increased appetite for customization across many consumer segments.

An estimated 36% of consumers5-- and 55% of US Millennials6 -- are interested

in buying personalized products and experiences, with many willing to pay a

premium. These requests include a desire for help with private placements,

taxes, philanthropy, stock options, and the management and refinancing of

educational and real estate debt.

4 https://www.wealthmanagement.com/industry/banner-year-deals-thanks-ria-consolidators5 https://www2.deloitte.com/content/dam/Deloitte/ch/Documents/consumer-business/ch-en-

consumer-business-made-to-order-consumer-review.pdf

6 https://www.uspsdelivers.com/why-personalization-may-help-you-win-with-millennials/

PRICE ISN’TTHE BARRIER

WILLING TO PAYA 20% PREMIUM

consumers who expressedinterest in personalized products or services are

1 in 5

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Industry trends


based paradigm

Separately Managed Accounts (SMAs) have grown significantly since the

financial crisis7, in part due to the flexibility they offer in terms of tax-efficiency,

customization, transparency, and professional management. Firms from Morgan

Stanley to Goldman Sachs tout their ability to personalize portfolios, though

they generally reserve these services for their wealthy clientele because, when

stock selection, portfolio management, and client interactions are all conducted

by people, SMAs are only economically viable for clients with several million in

investable assets.

All told, the investment management industry is moving from a one-size-fits-all

approach to an age of personalization8.

7 https://www.investmentnews.com/article/20140815/BLOG09/140819939/why-separately-

managed-accounts-are-undergoing-a-rebirth

8 https://www.wealthmanagement.com/client-relations/personalization-key-winning-emerging-

investor-loyalty

Source: Deloitte9

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Industry trends


based paradigm

Increasing Demand for ESG Investments

and Corporate Data

In the coming years, investors will increasingly move their assets to impact

issues they care about. Industry bodies currently estimate that ESG-linked

assets comprise $12 trillion in the US and $30 trillion globally, with one report

showing the segment growing at 17% per year.10

9 https://www2.deloitte.com/content/dam/Deloitte/ch/Documents/consumer-business/ch-en-

consumer-business-made-to-order-consumer-review.pdf10 https://www.institutionalinvestor.com/article/b15cc1dxds8k97/mckinsey-esg-no-longer-niche-as-

assets-soar-globally

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This rapid growth has also increased the demand for ESG data from asset

managers. Historically, company sustainability disclosure has been lackluster,

sporadic, and PR-focused, not impact-oriented. However, as shareholders have

joined forces to demand better disclosure on ESG issues, issuers have begun

to respond:

Eighty-five percent of S&P 500 companies published sustainability or

corporate responsibility reports in 2017, compared to less than 20% of

companies reporting ESG data in 2011.12

Companies reporting environmental impact data to the nonprofit CDP now

comprise over half of global market capitalization. Over 7,000 companies

reported last year, up 11% from the year before.13

$0

1995 1997 1999 2001 2003 2005 2007 2010 2012 2014 2016 2018

$2,000

$4,000

$6,000

$8,000

$10.000

$12,000

$14,000

Figure A

Sustainable and Responsible Investing in the United States 1995-2018

ESG Incorporation Overlapping Strategies Shareholder Advocacy Graph sourced from

ussif.org11

11 https://www.ussif.org/sribasics12 https://www.ga-institute.com/press-releases/article/flash-report-85-of-sp-500-indexR-

companies-publish-sustainability-reports-in-2017.html13 https://www.cdp.net/en/scores

To

tal A

sse

ts in

Bill

ion

s

11

Industry trends


based paradigm

$0

2003 2004 2005 20072006 2008 2009 2010 2011 2012 2013 2014 2015

1000

2000

3000

4000

5000

6000

7000

8000

2016 2017 2018

Total disclosing companies

Companies disclosing on climate change

Companies disclosing on water security

Companies disclosing on forests

Graph sourced from

CDP.net15

14 https://sustainableinvesting4all.com/great-web-sites/sustainable-investing-research-and-ratings/15 https://www.morningstar.com/blog/2018/05/11/fund-fee-study.html

As the availability of ESG data increases, the costs for investors to source this

data is expected to decline. The proliferation of ESG data providers is likely to

accelerate this trend, lowering the barrier for investors to make use of ESG data

in their investment decisions.14

# o

f co

mp

an

ies

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Industry trends


based paradigm

These concurrent trends combine to create a status quo unlikely to persist. To

recapitulate:

The incumbent product set is expensive. According to a 2016

Morningstar study, actively managed equity funds charge an average

expense ratio of 1.45%, compared to 0.73% for index mutual funds and

0.23% for ETFs.

Mutual funds are pre-packaged by design, and represent a static ethical

investing framework unsatisfactory to ESG-focused clients. Currently,

if a clients’ views diverge from the asset manager’s, they do not have the

ability to influence the asset manager’s approach or the fund’s holdings.

Additionally, while fund managers can customize a fund’s holdings to a

client’s requests if the client’s assets are held in an SMA, most institutional

asset managers only make SMAs available for multi-million dollar

accounts, meaning investors can only expect a customized portfolio if

their assets rise above a relatively high level.

The “Great Wealth Transfer” is underway. In this transfer, more than $30

trillion is expected to pass from the richest generation, Baby Boomers,

to their children and grandchildren, Millennials and Generation Z16.

These later generations are bigger17, more diverse18, and more socially

conscious19 than the ones that came before, and they expect products and

services from companies with a conscience.

Investment Management is Ripe

for Disruption

16 https://www.investopedia.com/advisor-network/articles/great-wealth-transfer/17 https://money.cnn.com/interactive/economy/diversity-millennials-boomers/ 18 https://www.npr.org/2018/11/15/668106376/generation-z-is-the-most-racially-and-ethnically-

diverse-yet19 https://www.forbes.com/sites/sarahlandrum/2017/03/17/millennials-driving-brands-to-practice-

socially-responsible-marketing/#44e3a3d4990b

-600

2000 2001 2002 20042003 2005 2006 2007 2008 2009 2010 2011 2012

-400

-200

0

200

400

600

800

$1,000

2013 2014 2015 2016 2017

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Industry trends


based paradigm

Two-thirds of Millennials and Gen Z20 expect companies to personalize

their offers. The growth in consumer-facing technology has changed

expectations of the costs and ubiquity of customized solutions.

Account personalization is easier and more modular than ever before.

This change is largely spurred by the growing availability of ESG data and

the dramatic drop in transaction costs, especially trading costs.

The movement towards quantitative passive strategies has been a catalyst for

the industry to shift towards fully automated security allocation and trading.

Similarly, as ETF prices near zero, the industry will be forced to consider new

business models less dependent on volume.

21 https://www.morningstar.com/blog/2018/05/11/fund-fee-study.html

Exhibit 4

The Shift into Low Fee-Ranked Funds Accelerates

Graph sourced from

Morningstar.com21

Cheapest 20% Remaining 80%

US

$ B

illio

ns

II.

The Post-Fund Paradigm

15


Back to the Future: Trading

Individual Securities

Ripple Effects: DCIs and Smart

Tax Management

As these trends grow, they continue to erode the benefits of mutual funds

and ETFs. Technology is making it increasingly possible for investors to buy

individual securities aligned with personal values and tax optimization at

acceptable costs. Investors and advisers may create their own index funds, an

approach that would disintermediate existing fund managers.

From these macro-trends, which industry expert Michael Kitces hypothesizes

will all overlap, ESG could break out of a specialized investment product to

become a mainstream feature.22

Tax loss harvesting (the practice of selling securities that have sustained losses

to reduce a portfolio’s tax liability) presents a significant opportunity for DCIs

22 https://www.kitces.com/blog/indexing-2-0-how-declining-transaction-costs-and-robo-indexing-

could-disintermediate-index-mutual-funds-and-etfs/

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The value of tax loss harvesting ranges from 0.15% to more than 0.70% annually

over a customer’s lifetime23. Since approximately one quarter of U.S. corporate

stock is held in taxable accounts24, many investment advisers offer tax-loss

harvesting. However, this exacting trading work is often done manually and

annually, with its effectiveness limited in investment vehicles like mutual funds

and ETFs.

The algorithmic trading technology underlying DCIs is uniquely suited to this

kind of repeated, systematic task. As DCIs hold individual securities, they

allow much greater granularity (and therefore greater impact) of tactics like tax

loss harvesting, while minimizing the risk of human error in execution. Both of

these features can provide benefits to clients leveraging DCIs to perform more

precise tax loss harvesting, a valuable feature of this new investment vehicle.

The Limitations of DCIs

As outlined, DCIs present a number of opportunities and solutions to current

challenges faced by financial advisors when investing their clients’ assets. DCI’s

benefits do, however, come with their own drawbacks:

DCIs can be expensive. As a relatively new technology, the offering has

not been commoditized, and can therefore be priced at a premium. This

is not an inherent feature of the technology, however, and is likely to

decrease over time.

23 https://www.nerdwallet.com/blog/investing/just-how-valuable-is-daily-tax-loss-harvesting/24 https://www.taxpolicycenter.org/taxvox/only-about-one-quarter-corporate-stock-owned-taxable-

shareholders

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DCIs do not perfectly track their underlying reference. This problem

is not unique to DCIs; all index-tracking investment products face this

challenge, with tracking error providing a tool to monitor any significant

deviance from the reference. Like most index-tracking products, however,

most DCIs will track their reference indices well enough to meet an

investor’s goals.

Many providers of direct indexing require high minimums. Wealthfront,

for instance, sets a $100,000 threshold for clients invested in their

direct indexing solution. Note, however, that direct indexing does not

necessitate a high account minimum, especially with the advent of

fractional shares, so this drawback of DCIs is likely to diminish over time.

Specialized software can be expensive. An adviser cannot reasonably

track the Russell 3000, for example, by hand, as she would need to

regularly perform thousands of trades

Additionally, while adoption of DCIs is expected to accelerate, the financial

services industry does exhibit structural barriers expected to slow DCI adoption:

The investment industry is inherently sluggish. The industry is highly

regulated, and its members are typically cautious or reluctant in their

adoption of new technology.

Investment advisory firms rely on legacy technology. This technology

is typically held over from an earlier wave of terminal-based and non-

cloud mainframe computing, and these firms will not replace their

legacy systems without extensive and time-consuming risk management

analyses.

The existing client base exhibits a lot of inertia. This observation is

supported by high retention rates, and may be due to the customer

base being price- and quality-insensitive. After all, if a client is personally

interested in investing and finance, they might forego an adviser’s

services entirely.

18


Approaching the Tipping Point

We expect the transition to DCIs to follow Everett Rogers’ Diffusion of

Innovations model, which describes how current and potential adopters

interact:

The Early Adopters will adopt DCIs once a rational economic threshold

is reached and the costs to use this new technology are comparable to

existing equivalent options. (That rational calculation, however, will also

include a calculation of the enterprise value they can achieve from gaining

long term market share by acting as an early adopter and sustaining

higher margins for longer periods.)

The larger, slower majority will be motivated to make the shift after

large industry players see the competitive threat and race to catch up.

19

0

Categories of Adopters

Market Share %

Innovators2,5%

Early Adopters 13,5%

Early Majority34%

Late Majority34%

Laggards16%

25

50

75

100

Diffusion of Innovations

by Everett Rogers

Graph sourced from

Total Product

Marketing25

Market Share Technology Adoption Bell Curve

A number of tipping points could accelerate the industry’s movement toward

this high rate of DCI adoption.

25 https://totalproductmarketing.com/risk-of-adopting-cloud-computing-overcome/diffusion-

innovation-bell-curve/

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Market Forces Pushing Asset Managers Downstream

Increased Competition between Asset Managers and

Financial Advisers

As margins erode in investment products, asset managers will move

downstream to the next tier of prospective clients. They recognize that when

technology transforms an industry vertical, the only margins that ultimately

remain are where the human relationship remains, between an adviser and

their client.

These asset managers are responding to dissolving trading fees and other

revenue streams, resulting from the inverted yield curve and increased

regulations.

Earlier this year, Blackrock purchased Aladdin Wealth, adding it to their

FutureAdvisor robo solution. Goldman Sachs also purchased United Capital,

a platform with 22,000 registered investment advisers. These acquisitions put

asset managers in direct competition with financial advisers in capturing the

mass affluent client.

In response, wealth management platforms are increasing their offerings

of private-label asset management solutions. In short, they are seeking to

become investment product manufacturers. A distributor moving upstream

into manufacturing will surely seek to leverage its core competency: client

knowledge. Advisers know about clients’ life events, family situations, and

personal values. By implementing a software-based approach to manufacturing

(i.e. custom direct indexing) advisers can manufacture solutions on the spot

that are objectively superior for the client, sustain higher margins, and are well-

defended against the offerings of companies like Vanguard.

21

The Post-Fund ParadigmThe Future Starts Now

DCIs are the next evolution of financial technology. Their growing adoption by

industry players might foretell the future of the investment industry, which is

furiously re-tooling and rebranding to meet demand for customized products,

values-based investing, and smart tax management, particularly from Millennials

and Gen Z. In parallel, the commoditization and tumbling costs of ESG data and

trading services seem likely to remove the remaining barriers to widespread

DCI adoption.

As science fiction author William Gibson said, “The future is already here,

it’s just not evenly distributed.” DCIs are the future, on their way to be widely

distributed.

22

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