Wealth Management
A recent article from Morningstar’s John Rekenthaler discussed the tax benefits of direct indexing. Direct indexing is a strategy that involves directly buying the stocks of an index rather than through a fund.
This confers several benefits such as allowing investors to gain the benefits of indexing while still being able to customize their portfolio to reflect their values and better fit their needs. Due to this, the category has exploded and gone from a niche offering solely for high net-worth investors to being offered by retail brokerages to customers for as little as $5,000.
However, the strategy is not necessarily for everyone, but it can be particularly useful for those with sizeable assets due to the potential tax benefits. This is because direct indexing results in capital losses in a separate account when stocks drop below their cost bases. The proceeds are then re-invested in stocks with similar profiles.
This strategy can be particularly useful for investors with high federal and state taxes, large amounts of money invested in direct indexing vs other investments, short-term capital gains, and dealing with a volatile market environment.
FinSum: Direct indexing comes with several benefits for clients but the most substantial one is the tax savings. However, it’s only worthwhile for a particular group of investors.
According to Daniil Shapiro of Cerulli Associates, there is a major product development opportunity for active fixed income ETFs in the coming years. A variety of factors are behind this segment’s growing popularity including the increasing acceptance of the ETF structure, growth of advisors who are comfortable with fixed income ETFs, and rising rates which lead to increased structural demand for fixed income products.
The report was compiled by Cerulli Associates based on polling of financial advisors and was covered by Kathie O’Donnel in an article on Pensions & Investment.
The major takeaway is that use of fixed income ETFs by advisors is rapidly growing with 70% reporting use in 2022, up from 63% in 2021. Most ETF issuers pointed to greater advisor acceptance of the product and institutional demand as drivers of the ETF market. Among issuers, 66% see fixed income as their primary focus which exceeded equities at 57%.
Overall, this survey reveals that there continues to be opportunity for ETF issuers in the active fixed income space, given rising demand. While there are plenty of options in passive fixed income, there are relatively less active options.
Finsum: The fixed income ETF category is rapidly expanding. Within the space, passive is saturated but plenty of opportunity remain for active managers especially given expectations of rising demand in the coming years.
According to an article by Todd Rosenblum of ETFTrends, a survey of financial advisors revealed that 68% of financial advisors gain fixed income exposure for clients through bond mutual funds, followed by bond ETFs at 61% and individual bonds at 58%.
Yet, the category continues to grow at an impressive rate with about $45 billion of inflows into US-listed bond ETFs. In total, bond ETFs have $1.3 trillion in assets which comprises 20% of the overall base, indicating more room for growth.
Some of the major advantages of bond funds such as ETFs or mutual funds are increased diversification and opportunities to enhance returns which can’t be found when buying individual bonds.
Bond funds can even be bought with a specific maturity date when your client may have a need for liquidity. It also avoids the risk of a credit downgrade or default which is elevated in an individual security. Another is that bond ETFs are much more liquid and with tighter spreads than individual bonds. Additionally, many of the most liquid and popular fixed income ETFs invest in hundreds of bonds issued by high-quality companies.
Finsum: Fixed income ETFs are a fast growing category but still trail behind fixed income mutual funds in terms of popularity with advisors. However, it does offer major benefits compared to investing in individual bonds.
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Regulators are looking to get more aggressive about enforcement of Regulation Best Interest (Reg BI) which was passed in 2020. Regulators are particularly focused on sales practices to ensure that fiduciary standards are followed according to a Thomson Reuters article by Richard Satran.
Reg BI mandates that recommendations are offered with impartial advice and explanation of alternatives, including to competing firms. Along with the SEC, Reg BI has also been adopted by the Financial Industry Regulatory Authority (FINRA).
One challenge for firms and regulators is that automated monitoring of transactions to ensure compliance is lacking. According to Parham Nasseri, VP in product and regulatory strategy at compliance software developer InvestorCOM, Inc: “Putting the risk assessments into a surveillance system for Reg BI compliance involves significantly more challenges than the kind of monitoring that systems have done in the past.”
New elements to monitor include conflicts of interest, customer profiles, costs, alternative investments, and other client-specific factors. Along with the technological challenges, firms will have to comply with new exam requirements to comply with new sales practice rules.
Finsum: Reg BI was passed in 2020 but regulators were slow to begin aggressive enforcement given the pandemic. This is changing and firms will be forced to rapidly update sales practices, training, and monitoring.
Given increasing volatility in financial markets, it’s not surprising that many investors are feeling nervous. According to Corebridge President Bryan Pinsky, annuities are one option for investors to reduce the volatility in their portfolios and prevent them from making rash decisions. His perspective was shared in an article by Allison Bell for ThinkAdvisor.
Corebridge Financial is ranked third in terms of individual annuity sales at $20 billion and was previously known as AIG Life & Retirement. He believes that negative emotions during volatile markets often lead investors to sell low and buy high.
In terms of his thoughts on the current market, he said that the doubling in the yield of the 10-year Treasury note in 2022 was historically unprecedented. It’s also resulted in annuities paying out higher rates which has led to a surge in demand for these products.
He says that the elevated market volatility since the end of 2021 have validated the use case for annuities. He also doesn’t believe it’s too late to seek downside protection and that annuities can be an integral part of any retirement portfolio with recommended allocations between 10% and 30%.
Finsum: According to Corebridge’s Bryan Pinsky, market volatility has proven why annuities are an essential part of any investors’ financial plan. Additionally, he believes that buying conditions for annuities remain attractive.
Until recently, customized portfolios were only available to high net worth individuals. But, this is now changing due to the advent of direct indexing which is giving these tools to a much wider swathe of investors according to an article from Michelle Lodge.
Direct indexing allows investors to have more control over their money while still allowing them to benefit from the positives of indexing such as diversification, tax efficiency, and low costs. This will allow their investments to better reflect their life situations, values, and convictions.
It’s particularly useful for those with outsized exposure to a company or an industry or those with a large base of taxable assets. For instance, a tech employee with a large number of shares and stock options could use direct indexing to purchase the S&P 500 but reduce exposure to technology stocks.
According to BlackDiamond Wealth CIO Ken Nutall, “We have two main use cases: clients who have an old portfolio of appreciated assets but want to migrate to another strategy of tax efficiently, or [those who] work at a bank and don’t want any more bank exposure in their portfolio.”
Finsum: Direct indexing is one of the fastest growing areas of wealth management. It gives investors the benefits of index investing, while allowing customization to help clients achieve their financial goals..