Why Canada would benefit from 'direct index' investing – The Globe and Mail

Traditionally reserved for institutions and ultra-high net worth individuals, direct indexing is a hot topic for investors as technology advances and downward pressure on retail trading commissions have done much to democratize its access. In the United States, direct indexing strategies are expected to outpace the growth of both ETFs and mutual funds. In response, U.S.-based providers are scrambling to build, buy or partner to acquire the required capabilities to get in on the action, driving down the costs and required account minimums for investors. For Canadians, it’s worth getting a better understanding on what Direct Indexing is, and what we can expect for the future of these strategies north of the border.

As a brief overview, direct indexing amounts to personalization at scale. Similar to a traditional investment fund, direct indexing gives individual investors a way to get exposure to a broad segment of the investment market, such as an equity index. Unlike traditional funds, however, direct indexing involves individuals investing directly in the underlying securities (stocks or bonds that make up a larger index), instead of simply buying units of a fund. Investing in this way offers multiple benefits. First, there are a variety of tax strategies (most notably tax loss harvesting) made available by directly holding the individual securities, which can add a potential 1-3% after-tax return on an annual basis. Second, the investor would have near-full autonomy to incorporate their personal preferences for the purpose of excluding securities that do not align with their values or investment objectives. Consider an index that is made up of the 500 largest companies listed in the United States, when investing in this product the investor does not have the choice of what companies make up this portfolio, meaning they may be required to invest in companies that do not align with their values or investment objectives. However, by holding the underlying securities, these non-aligned stocks can be excluded from the investor’s portfolio. While traditional thematic ETFs and mutual funds provide generic options for investor choice, the opportunities for hyper-personalization inherent in direct indexing strategies are almost endless.

As a concept, direct indexing is not new. Sophisticated investors, such as institutions and wealthy investors, have long held the requisite buying power and influence to overlay all manners of unique constraints on their investment portfolios. However, technology advances that could handle significant scale coupled with reduced trading costs brought this concept into the hands of individual investors – the former made it possible for investment managers to offer direct indexing while the latter made it affordable for the retail market.

The seismic nature of this shift cannot be undersold. Consider an investment advisor seeking to satisfy the individual needs of their clients across 10,000 individual investment portfolios. They’d need to manually ingest a mountain of client-level information, go about buying into hundreds of thousands of individual securities and monitor all accounts to identify portfolios that require rebalancing when they drift out of alignment. Prior to the advances described above, this would be cost- and time-prohibitive. Direct indexing offers this high degree of personalization in an automated fashion that is feasible for the investment manager, while better serving individual client needs.

When compared to the U.S., Canada has been slower to internalize the required pre-conditions to support direct indexing, but the outlook is increasingly positive. Leading direct indexing technology-solution providers in the U.S. are expressing interest in Canada as an expansion target. Additionally, Canadian broker-dealers are exploring ways to enable zero commission trading at scale. Fractional shares, at one time considered more of a marketing gimmick, is also slowly finding its footing as firms are tapping into lower account balance investors that are seeking alternatives to traditional funds.

Beyond these structural considerations, it’s worth examining whether demand among Canadian investors will be sufficient to justify bringing direct indexing to the Canadian market. For instance, the main driver for adoption of direct indexing in the U.S. is the opportunity to capture additional after-tax returns through direct indexing’s optimization capabilities. However, given tax code differences in Canada related to the treatment of capital gains, the benefit provided from tax optimization strategies deployed on Canadian portfolios will likely be less than those experienced by our counterparts south of the border. That said, believers in the concept remain steadfast that the increase in personalization for Canadian investors will be enough to drive demand for direct indexing.

Direct indexing likely still has a place in the Canadian investment landscape, despite the differences between Canada and the U.S.. The first ‘Canadianized’ direct indexing solution made available to the mass-market will have to navigate Canada’s structural nuances; if done successfully, investors aim to significantly benefit by accessing institutional investment capabilities at a cost likely competitive with most Canadian mutual funds.

Michael Thomson is director, and Jeffrey Joynt a consultant, with Alpha Financial Markets Consulting

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