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A Conversation about Direct Indexing with IDX Advisors

This post is part of the Expert Interview series, which showcases some of the smartest thinking in the financial services industry on issues that matter most to advisors. If you would like to suggest a speaker or topic, please email your ideas to:

Andrew Swan is the Principal and CEO of IDX, and former President of Bastion Quantitative Sciences. Prior to that, he served as Managing Director of Longboard Asset Management, where he led the liquid alternatives division, which grew to $1 billion in assets in under four years. He has a BS in Finance from Arizona State University. Ben McMillan is the Principal and CIO of IDX. He was a founder and former portfolio manager at RQSI, where he launched the RQSI Small Cap Hedged Equity Mutual fund. Prior to that, he served as co-portfolio manager of the Van Eck Long/Short Equity Index mutual fund and developed the Lyster Watson Long/Short Equity Replication strategy. Ben holds an MS in Econometrics from the London School of Economics, and an MA and BA in Economics from Boston University.

Vigrass: Let’s start with some background first. Tell us about the history of IDX, and what IDX does.

Swan: IDX was formed a couple of years ago, but it was based on a lot of foundational work we did at other institutions. We started seeing interest from the institutional investor community in direct indexing about ten years ago. Back then, we were calling it “investable benchmarks.” At Lyster Watson, we began providing hedge fund replication-style investable indexes. Fast forward to today: IDX was developed to serve that direct indexing niche, but for a broader audience, leveraging technology that’s now available, like Folio’s platform.

Vigrass: You have a very specific philosophy when it comes to direct indexing. What is responsible indexing, and what are the some of the common pitfalls to avoid?

McMillan: IDX spends a lot of time researching and developing criteria around responsible indexing. While the explosion of indexes in the last 5-10 years been democratizing for investors, complexity has increased, some of which is warranted but much of which is not.

We’ve got some rules of thumb with which we approach every index we create and audit. We start by asking whether the rules are intuitive enough that you would invest in the index without ever having seen a back test. If the answer is no, then we ask whether the rules were created by the data as opposed to using the data to test the rules; it’s a very simple, but subtle and powerful, question.

For example, we looked at an index based on the ten spider S&P sectors, which had two rules, one for selecting the sectors based on a value metric and one for selecting them on the growth metric. We went through the exercise of changing one of those rules (eg, the threshold), for every parameter combination. This gives you a good idea of how fragile a particular index is. We talk about “indexing as a service” a lot; the service component means not spending as much time upfront trying to create the most complicated index, but on the backend, ensuring that the index is robust and repeatable.

Vigrass: You talk a lot about a tax alpha. Can you go into detail, and provide an example?

Swan: Tax alpha and tax management to IDX, means getting the best after-tax net result for a portfolio of indexes. If investors really want to manage their entire asset base, they should work with their advisors to understand their tax situation fully. We work with some very smart partners, like Folio, who have either created very good tax management technologies or spend 100% of their time focused on tax optimization via overlays.

First, we consider tax loss harvesting, because you want to create the lowest net tax liability over the life of the portfolio. You should take advantage of early losses in the portfolio, particularly short-term losses, and harvest them from the portfolio to offset future taxable gains. As the portfolio matures, the focus becomes gains deferral, or minimizing realized gains during the rebalancing process. For example, if you owned both Coca Cola and Pepsi stock, and you had a large taxable embedded gain in Coca Cola but not in Pepsi, you would want to look at limiting your exposure to Pepsi, while avoiding the larger taxable event in Coca Cola.

Vigrass: What do you think about the industry buzz around direct indexing potentially overtaking ETFs in popularity? What differentiates ETFs and direct indexing. What are the benefits of one versus the other?

McMillan: We refer to direct indexing as the next evolution of ETFs. Prior to the original ETFs, short of investing in a mutual fund, if an investor wanted access to a diversified basket of 500 stocks, they’d have to invest over $1 million. Historically, spreads have been much wider, so an ETF was a very cheap way to get that diversified exposure. Ironically, that has reversed. As ETFs have become popular and costs have come down, those advantages are reduced. Investors have also gotten more sophisticated; they’re looking at customized exposures, which the ETF landscape cannot address.

Direct indexing is simply owning shares directly, without having to go through pooled vehicles like ETFs or mutual funds. With the advent of technology like fractional shares and SMA and UMA platforms, ETFs no longer have superior advantages ̶ not that we’re negative about ETFs, which are still a very effective means of getting exposure to asset classes outside of equities, primarily fixed income and commodities.

Vigrass: What are the trends? Where do you see it all going?

Swan: Technologies like Folio’s for trading and rebalancing of fractional shares make it reasonable to execute direct indexing for the masses. Instead of passive ETF investing, investors now want to see how else they can improve upon the asset allocation mix, especially for larger taxable accounts. If you want to customize an index portfolio ̶ for example for ESG or SRI preferences, or because you have a large holding in a company and you want to diversify away from that particular industry ̶ direct indexing gives you the flexibility to tailor your investment portfolio to your particular needs, and ultimately get what you hope to be the best net after-tax result.

Vigrass: Talk a little about your partnership with Folio.

Swan: IDX provides index models on the Folio platform. Advisors can consult with us if they want a custom direct indexing portfolio for one of their clients. From there, Folio has Tax FootballTM and other tools to help advisors efficiently manage those portfolios to get the best after-tax result. Folio’s technology is really streamlined, and it makes our business efficient and advisors’ lives easier.

Want to hear more from IDX Advisors? Listen to the full interview.

Expert Interview