Barrett Ayers is the President of Adhesion Wealth, a leading provider in outsourced managed account solutions. In this episode of Power Your Advice, Doug Heikkinen and Barrett discuss direct indexing – what it is, how it works, and why you should consider it for your clients’ portfolios.
- The history of direct indexing, and how it has become available outside pooled vehicles
- The potential tax benefits of utilizing a direct index within a Unified Managed Account (UMA)
- An overview of Adhesion Wealth’s Personal Index solution, and why Barrett is so excited about it
- How leveraging direct indexing can help your clients and bolster your value proposition
Resources: Adhesion Wealth
Douglas Heikkinen, Barrett Ayers
Douglas Heikkinen 00:00
Hello, and welcome to the power your advice podcast. The power advice podcast is designed to bring financial advisors new ideas, why those ideas should be considered and how to implement them into your business. This podcast is brought to you by advisorpedia, the best place advisors can come to to grow their minds and businesses. . .
Barrett Ayers 00:47
Hey, Doug, how are you today?
Douglas Heikkinen 00:48
I am good. How has the year been so far?
Barrett Ayers 00:52
Well, so far, so good. You know, I think we're starting to see business return back to normal. And I think the topic we're going to be chatting about here today, I think is particularly applicable for the state of the markets and the growth of the advisory business.
Douglas Heikkinen 01:07
Yeah, as I was doing a little bit of research on today's topic. It's really, really interesting direct investing. So and it's also something you guys do really well. So let's let's jump into it. Um, what is direct indexing? And why should advisors consider it for their client portfolios?
Barrett Ayers 01:27
Yeah, so interesting, you know, and you're right, there's a lot of there's a lot of noise out there right now about direct indexing. And I think I'm really excited, we have an opportunity to chat here today and kind of step back and you know, almost to kind of introductory or primmer to kind of what direct indexes are. So a direct index is really a way to replicate the risk reward profile of a benchmark an index like the s&p 500, or the Russell 1000, or 3000. You know, there's most advisors believe that there's a place and a time for a either direct index or some sort of index, investment holding inside their clients portfolio. And most of them up until, you know, maybe the last 1015 years, the only way to get access to that index exposure index, like exposure was through a mutual fund, or an ETF. The challenges with those of the mutual funds are relatively expensive, and the ETF, well, a little bit more affordable, is just an individual single holding in the client's portfolio. If you want to buy the s&p 500, you buy one single ETF. So the direct index is really designed to take that one step further and say, You know what, let's open up, let's crack open this, this index, and let's put those holdings inside the client account. So the client can have individual holdings, so therefore, they have transparency into the underlying holdings, it's their own tax slots inside their account, which means then that they can do things like personalize it, maybe they want to put a tilt on it, maybe the client wants to tax manage it. Unfortunately, with an ETF or a mutual fund, where there's a single holding, it's relatively difficult, it's difficult, if not impossible, to tax manage that single old day. Now that you have multiple, many tax slots in the client account, not only can you customize it, you can also tax manage it, you can do active harvesting, and things of that nature, to really create some benefits to the client, while still following the actual index. Now, there's many forms that direct indexes take, right so you could if you wanted to, you could take the s&p 500, open it up, and you could stick all 500 Holdings into a client account. That's very difficult, in that the size of the account, in order to get all shares has to be a very large account. So that was generally held only for exceedingly high individuals, ultra high net worth clients. The other approach is what some folks are doing now, which is fractional shares. So maybe you've got $100,000 account, and you can get a little bit of all the holdings and let's say the s&p 500. The challenge there is it's operationally difficult if not impossible to actually trade those particular securities. Many custodians don't allow fractional shares, and you certainly can't trade them over institutional trading connections called fix. So the last option, which is what adhesion does is we do what's called optimization. We take let's say, with the s&p 500, we apply an optimizer which tries to compare multiple factors, and distill down the index from let's say, 500 Holdings to maybe 100 Holdings, or 75 holdings. And most of the characteristics and attributes of the index can be found in a much smaller set of names. And so that's what we've been doing for the last 12 years is managing a much smaller, distilled optimized version of the index. In client accounts. It's therefore affordable and accessible to clients and then maybe $100,000 range, let's say, so now it's much more available and accessible to the masses and therefore the investment advisory community. Something that we think is is pretty exciting.
Douglas Heikkinen 05:00
So as he mentioned in the past advisors and investors were only able to do this through mutual funds, which we all know are really expensive. And ETFs, which are much more expensive than people think they are. Was there something that changed, that allowed direct indexing to happen? Or was it something that was always available? And people just started to figure it out?
Barrett Ayers 05:20
Well, I think, Well, I think the market, the market became more mature. First of all, I think one of the things that happened, and we've talked about this before, is with fee compression. I think a lot of a lot of advisors needed to find ways to get the overall portfolio product costs down. So suddenly, there was a need that emerged kind of on the scene a couple years ago, were advisors were starting to say, geez, you know, how can I get the total blended cost of my portfolio down? So there in that, then we started talking a little more about direct indexes. The challenge with most direct indexes, however, is it's one of many holdings inside of a typical portfolio, you may have a core, and then you've got, you know, maybe some satellite holdings. And so one of the challenges were, you know, geez, how do I put historically, I'd put a mutual fund in there for an index, and then I might put a couple ETFs, and maybe a separate account manager in there, too. But the minute you start to open that up to lots of holdings, you needed something like the unified manage account, which, again, is what adhesion does, to really unlock the power of all that keep that organized. So what adhesion does, and this is really, the reason we got into the business about 12 years ago with direct indexes is you can take a direct index with, let's say, 100 Holdings, and you can put it as a core instead of a single account, then you can go use managers, mutual funds, ETFs separate accounts in the same account, and kind of wrap those satellite holdings around the core direct index. And the benefits then are, operationally it becomes very easy to manage a single account. And then you can also do some other exciting things like tax manage, and offset trades that are happening in the satellite against all these holdings in the much larger core. So I think it was really it was really the the industry pushed because it needed it. And I think then along came this vehicle called the unified managed account that allowed it to become organized and structured in a way that advisors could truly harness it.
Douglas Heikkinen 07:16
Is there an ideal client type for these solutions? Or did they work for both large and smaller clients? And is this where fractional shares come into play as well?
Barrett Ayers 07:26
Well, you know, I think, I think there's a place for large and small clients, I think, you know, if you first kind of define what the account size needs to look like, we believe that it's, it should be something that's available to all advisor and client types. So we typically talk to advisors about if they want to use a direct index, and they're working with adhesion, 50 to 75,000 is probably the right entry place for it to make it make sense. And from there, you probably want to allocate maybe 4050 60%, to the direct index. And now you're building kind of this core satellite portfolio. And then you can put a handful of satellite managers around the outside of the direct index. And when you do that, you're really only talking about 100 250 to $200,000 account type. You obviously it scales up very nicely with larger accounts. So we don't really think that in an optimized version of a direct index, that there's really much in the way of account minimums, we really believe that it's important, especially for for clients who are taxable. To understand the tax benefits of direct indexing, it really is a powerful vehicle to generate tax alpha, and, and even in many cases, reduced the trading, the trading in that the direct index can be the absorption point. For the satellite managers, if you think about the way that works, instead of a single account, you may have a large direct index in the middle and you've got one of the satellite managers selling apple. Well, rather than sell it and generate a commission in taxable event, we can just absorb it into the core, because let's say we have apple in the direct index. So we just bring it into the into the core. So next thing you know, not only you're not generating taxes, you're not generating commissions and heavy transaction costs and the ability to absorb things into the direct index cores a real real powerful tool as well.
Douglas Heikkinen 09:18
So the tax benefits of utilizing a direct index inside of UMA must be fantastic.
Barrett Ayers 09:24
Yeah, and I think I don't think enough people understand that's a really good question. I don't think enough people really talk about that, because I'll tell you, there was a lot of people talking about direct indexes, a lot of marketing and advertisement out there about it. A lot of people are generating direct index models on their own, and they may create a direct index and they may open an account and they may invest it themselves for their clients, right. So they're not outsourcing the actual running of the direct index. And or they may be using one of these other firms that are doing direct indexes via SM Ma. So you could hire one of these money managers to manage an account for you and run a direct index in that account. The challenge with that approach is they're only looking at the direct index, right? There's other managers that you hired outside of the direct index, to also manage that client portfolio, you could have a large cap growth manager, you can have a small cap value manager, and all these managers aren't talking to each other. But when you stick them inside of a single account, suddenly, you supercharge the benefits of it. So what happens in the old world where you have a single standalone direct index, you don't might have been harvesting in there, you might have been buying and selling securities, but then you've hit your large cap growth manager off on the side not talking to the direct index, and he or she is generating losses, and they're generating trades all over the place. The result is you think you're doing really good things in both of these independent standalone accounts. But in reality, you're creating washe sales all over the place, someone selling Apple, someone's buying apple and another account. And so independently, you're doing great until you hand it all over to the tax, the tax person at year end. And he or she sees all these wash sales and disallowed gains losses. So it's a real mess. So what we do by putting inside of a single account adhesion operates is what's called an overlay manager, kind of like a quarterback. And we're making sure that we're not generating wash sales across managers. So we can do things like defer avoiding wash sales, we can do things like swapping tax slots. So again, if somebody is buying apple and someone selling it, we can just move them across sleeves. And that's a, that's a really important thing too. And obviously doing ongoing harvesting in the in the direct index to generate losses to offset against the gains in the satellite. So what happens is, at the end of the day, the satellite guys are generating gains all over the place, we're harvesting in the direct index core generating losses to try to offset the gains on the outside. And what happens at the end of the year is you've got kind of a relatively tax neutral portfolio, or lots and lots of tax alpha. And that obviously can be demonstrated to the end investor and shown why this is such a differentiated product with a lot of value.
Douglas Heikkinen 12:14
Doing this for 12 years, I can imagine you fine tune this again and again. And I imagine that with the personal indexes program, you can enable advisors to deliver personalized investment experience for their clients and really fine tune it to their needs and their desires and what they want to invest in.
Barrett Ayers 12:33
Yeah, it's, I tell you, I've been in the industry for, you know, 30 years, and I don't think I have been more excited about anything I had been associated with, then our recent launch of the personal index solution, I'm really proud of it. We've been working on it for a long time, we've been in the direct index business for 12 years. So personal index is basically saying, look, there's a direct index, starting point, right? So here's an s&p 500. And then we work with the advisors and we say, what do you want to do to this thing, and we're not asking them to be cfaes. And, you know, hardcore portfolio managers, we've got a modular overlay we put on top of so we talk to the advisors and we say, what do you want to do here, we have a whole library of ESG capabilities. And so we work with them to pick the ESG factors that are important to them. And then we distill down the index some more. And then we go next, we work on what we call our factor modules. So there's a handful of these kind of pre built modules that advisors can pick from like volatility dampening, or income production, or momentum. And so you can pick from any of these factor modules and lay them on top of the index as well. And then out pops your own personal direct index. And frankly, if you want to white, label that and call it your own, you know, advisor ABC personal index, we're happy to do that for you. And then the benefit is, once you're done, it's not a, an Excel file to go take somewhere else, we put it inside of our overlay our unified managed account platform, and the advisor can can click drag and drop accounts onto it. They can also layer other managers around it. And then they click a button and we run the whole thing for them. And obviously, they get insight and intelligence along the way about how it's doing. And it's really an exciting program, because, you know, it puts the advisor in the driver's seat, and let me tell you, it is a highly differentiated solution. So for advisors, who are looking to be a little bit different than the person down the street, who's got a six fund portfolio that they're pitching. It's highly differentiated, lots and lots of tax alpha, lots of ways to talk about it. And the other thing is, because this is a passive product at its core, it's not expensive, right? So if you allocate 4050 60% to a personalized index, it brings your total product cost down by like 60%. So your clients are getting a better product, they're getting it cheaper. It's highly differentiated. It's got your brand in front of it, and it represents the light style and preferences of the client. So it's getting a tremendous amount of excitement. We just launched it a couple months ago. And I, I was excited about it, but I didn't realize the excitement and demand and buzz it would have, it would have cost. So we're, we're really excited about that.
Douglas Heikkinen 15:16
Is this something where advisors need to recognize they need a direct investing solution? Or is it something that they go, you know, we really should look at this, because it adds a ton of value to our practice and our clients?
Barrett Ayers 15:29
Well, you know, what we're finding is that advisors don't really understand the direct index concept, right? I think for years and years, they've been they've been taught that to do that you need to be a poor, you know, a CFA or a portfolio manager, some expensive tool, they don't realize that it's something that can truly differentiate themselves and, obviously, deepen relationships with the clients and, you know, certainly make something that has a deeper connection with the with the client. So most of them don't really don't really understand what it is, until we sit down talk about it, it's really, it's, it's an investment model, we take it over, we run it for you. And, you know, you focus on what's important to you.
Douglas Heikkinen 16:16
We're sure listeners go and learn about more about adhesion and help them deliver the solution.
Barrett Ayers 16:22
So we would encourage you to take a look at adhesion wealth.com. That's our website, there's an area in there for both our direct index suite, which again, are kind of off the shelf, indexes that hold basically 100 holdings. And there's also a area for personal indexes, and we encourage you to take a look reach out, reach out to our solutions consulting team. And, you know, obviously, feel free to contact us and we'd be more than happy to set up a consultation and talk about how it works and how it's applicable for your business.
Douglas Heikkinen 16:55
Barrett, this has been super, I really think it's a great product. Thank you so much for joining us today.
Barrett Ayers 17:00
Fantastic. Thanks for your time.
Douglas Heikkinen 17:02
Remember, find out more about direct indexing at adhesion wealth.com for everybody at advisorpedia our producer Jakie Beard and the power your advice podcast team. This is Doug Heikkinen. Thank you
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