DIKSIA.COM - Passive investing has become increasingly popular among investors who want to gain broad market exposure at low cost. However, traditional passive vehicles such as index funds and exchange-traded funds (ETFs) have some limitations that may not suit every investor's needs and preferences. For example, index funds and ETFs do not allow investors to control the tax implications of their portfolio, customize their holdings according to their values and goals, or express their views on specific sectors or companies.
This is where parametric direct indexing comes in. Parametric direct indexing is a form of passive investing that enables direct ownership of the individual securities that compose a benchmark. Unlike an index fund or an ETF, it gives an investor greater control, allowing for tax-loss harvesting at the security level, customization around environmental, social, and governance (ESG) preferences, and other advantages.
In this article, we will explain what parametric direct indexing is, how it works, and who can benefit from it. We will also compare it with other forms of passive investing and discuss some of the challenges and opportunities that it presents.
What is parametric direct indexing?
Parametric direct indexing is a term coined by Parametric Portfolio Associates, a leading provider of direct indexing solutions for over 30 years. Parametric direct indexing is based on the idea that investors can replicate the performance of a market index by owning a subset of its constituent securities, rather than buying shares of a fund that tracks the index.
Parametric direct indexing uses rules-based models and algorithms to construct and manage portfolios that aim to closely match the risk and return characteristics of a chosen benchmark, while also allowing for various customizations and optimizations. Parametric direct indexing portfolios are held in separately managed accounts (SMAs), which give investors direct ownership and transparency of their holdings.
How does parametric direct indexing work?
Parametric direct indexing works by following a four-step process:
- Select a benchmark. The first step is to choose a market index that reflects the desired asset class, region, and style exposure. For example, an investor who wants to invest in US large-cap equities may choose the S&P 500® as their benchmark.
- Optimize the portfolio. The next step is to optimize the portfolio to achieve the best possible trade-off between tracking error and cost. Tracking error is the measure of how closely the portfolio follows the benchmark. Cost is the measure of the expenses incurred by the portfolio, such as trading commissions, bid-ask spreads, and taxes. Parametric direct indexing uses sophisticated algorithms to select a subset of securities from the benchmark that minimizes tracking error while also minimizing cost. The portfolio may not hold every security in the benchmark, but it will have similar risk and return characteristics.
- Customize the portfolio. The third step is to customize the portfolio according to the investor's preferences and objectives. Parametric direct indexing offers a range of customization options, such as:
- Tax management. Parametric direct indexing allows investors to harvest capital losses from individual securities, which can be used to offset capital gains and reduce tax liability. Parametric direct indexing also considers the tax impact of portfolio transitions, rebalancing, and withdrawals, and aims to optimize the after-tax returns of the portfolio.
- ESG integration. Parametric direct indexing enables investors to align their portfolio with their environmental, social, and governance values. Investors can apply screens to exclude certain industries or companies that do not meet their ESG criteria, or tilt their portfolio towards securities that have higher ESG ratings. Investors can also exercise their proxy voting rights and engage with companies on ESG issues.
- Other customizations. Parametric direct indexing also allows investors to make other adjustments to their portfolio, such as:
- Overweighting or underweighting specific sectors or factors
- Excluding or including specific securities or regions
- Implementing thematic or impact investing strategies
- Blending multiple benchmarks to create a diversified portfolio
- Monitor and rebalance the portfolio. The final step is to monitor and rebalance the portfolio to ensure that it stays aligned with the benchmark and the investor's preferences. Parametric direct indexing uses a dynamic rebalancing approach that considers the trade-off between tracking error and cost, and only trades when the expected value-add exceeds the expected cost. Parametric direct indexing also provides investors with regular reports and insights on their portfolio's performance, risk, tax, and ESG attributes.
Who can benefit from parametric direct indexing?
Parametric direct indexing offers a number of advantages, but it may not be ideal for all investors. Some of the factors that may influence the suitability of parametric direct indexing are:
- Account size. Parametric direct indexing requires a minimum account size of $100,000 for equities and $250,000 for fixed income. This is because smaller accounts may not have enough diversification or tax-loss harvesting opportunities to justify the cost and complexity of direct indexing. However, as technology and scale improve, the minimum account size may decrease over time.
- Tax status. Parametric direct indexing is most beneficial for investors who are subject to high marginal tax rates and have significant capital gains exposure. Investors who are in low tax brackets, have tax-deferred or tax-exempt accounts, or have capital losses carryforwards may not benefit as much from the tax management features of direct indexing.
- Customization preferences. Parametric direct indexing is ideal for investors who want to have more control and flexibility over their portfolio, and who have specific ESG, thematic, or impact investing goals. Investors who are satisfied with the standard exposure and composition of index funds or ETFs may not need the customization options of direct indexing.
- Cost sensitivity. Parametric direct indexing may have lower fees than actively managed funds, but it may have higher fees than index funds or ETFs. The fees for direct indexing include the SMA fee, the trading commissions, and the bid-ask spreads. The fees may vary depending on the account size, the benchmark, the customization level, and the trading frequency. Investors should compare the fees of direct indexing with the potential tax savings and value-added features to determine if direct indexing is worth the cost.
How does parametric direct indexing compare with other forms of passive investing?
Parametric direct indexing is not the only way to invest passively. Other forms of passive investing include index funds, ETFs, and robo-advisors. Here is a brief comparison of how they differ from direct indexing:
- Index funds. Index funds are mutual funds that aim to replicate the performance of a market index by holding all or most of the securities in the index. Index funds offer low-cost and diversified exposure to a broad range of asset classes and regions. However, index funds do not allow investors to customize their portfolio, harvest tax losses, or exercise proxy voting rights. Index funds also have minimum investment requirements, redemption fees, and capital gains distributions that may affect the investor's tax situation.
- ETFs. ETFs are funds that trade on an exchange like stocks, and that track the performance of a market index by holding a representative sample of the securities in the index. ETFs offer low-cost and liquid exposure to a wide variety of asset classes and regions. However, like index funds, ETFs do not allow investors to customize their portfolio, harvest tax losses, or exercise proxy voting rights. ETFs also have bid-ask spreads, brokerage commissions, and premium/discount risks that may affect the investor's cost and return.
- Robo-advisors. Robo-advisors are online platforms that use algorithms to create and manage portfolios for investors, based on their risk profile, goals, and preferences. Robo-advisors typically use index funds or ETFs as the building blocks of their portfolios, and may offer some level of tax management, ESG integration, and customization. However, robo-advisors may have limited choices of benchmarks, asset classes, and customization options, and may not be able to accommodate complex or unique investor needs. Robo-advisors also charge fees on top of the underlying fund fees, which may reduce the net returns of the portfolio.
What are the challenges and opportunities of parametric direct indexing?
Parametric direct indexing is a relatively new and evolving form of passive investing that has both challenges and opportunities for investors and advisors. Some of the challenges include:
- Complexity. Parametric direct indexing involves sophisticated algorithms, models, and processes that may be difficult to understand and explain. Investors and advisors need to have a clear grasp of the concepts and mechanics of direct indexing, such as tracking error, tax-loss harvesting, and portfolio optimization, to make informed decisions and evaluate the results.
- Communication. Parametric direct indexing requires frequent and effective communication between the investor, the advisor, and the direct indexing provider. Investors and advisors need to communicate their preferences, objectives, and constraints to the direct indexing provider, who in turn needs to communicate the portfolio's performance, risk, tax, and ESG attributes to the investor and the advisor. Communication is also essential to ensure that the portfolio stays aligned with the investor's changing needs and market conditions.
- Competition. Parametric direct indexing faces increasing competition from other forms of passive investing, especially ETFs, which have been growing rapidly in terms of assets, products, and innovation. ETFs may offer similar or better exposure, cost, and liquidity than direct indexing, and may also incorporate some of the features of direct indexing, such as tax management, ESG integration, and customization. Therefore, direct indexing may need to differentiate itself from ETFs by offering more value-added features and services.
- Regulation. Parametric direct indexing may face regulatory challenges or uncertainties, especially in terms of tax treatment, fiduciary duty, and disclosure requirements. Direct indexing may have different tax implications than index funds or ETFs, depending on the jurisdiction, the account type, and the portfolio activity. Direct indexing may also raise questions about the fiduciary responsibility and liability of the direct indexing provider, the advisor, and the investor. Direct indexing may also need to comply with various disclosure rules and standards, such as the Global Investment Performance Standards (GIPS), which may not be fully applicable or consistent with direct indexing.
Some of the opportunities include:
- Innovation. Parametric direct indexing is a fertile ground for innovation and development, as it leverages the latest advances in technology, data, and analytics. Direct indexing may benefit from the use of artificial intelligence, machine learning, natural language processing, and blockchain, to enhance the portfolio construction, management, and communication processes. Direct indexing may also create new possibilities for product design, such as smart beta, multi-asset, and dynamic strategies, that can cater to various investor needs and preferences.
- Education. Parametric direct indexing is an opportunity to educate and empower investors and advisors about the benefits and challenges of passive investing, and the trade-offs and choices involved. Direct indexing may help investors and advisors to understand the underlying mechanics and assumptions of market indices, the sources and drivers of portfolio performance and risk, the impact and importance of tax management and ESG integration, and the value and cost of customization and optimization.
- Collaboration. Parametric direct indexing is a collaborative effort that involves the direct indexing provider, the advisor, and the investor. Direct indexing may foster a stronger and more transparent relationship between the parties, as they work together to create and manage a portfolio that reflects the investor's needs and preferences. Direct indexing may also encourage a more holistic and integrated approach to wealth management, as it connects the portfolio with the investor's broader financial plan, tax situation, and ESG values.
Parametric direct indexing is a new frontier for passive investing that offers tax, customization, and ESG benefits. It works by replicating the performance of a market index by owning a subset of its constituent securities, while also allowing for various customizations and optimizations. It is suitable for investors who have a large account size, a high tax status, and a strong customization preference. It differs from other forms of passive investing, such as index funds, ETFs, and robo-advisors, in terms of exposure, cost, and control. It faces challenges and opportunities in terms of complexity, communication, competition, regulation, innovation, education, and collaboration.