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by Alex Steger, EDITOR, CITYWIRE USA
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There was much that was unexpected about 2020. Few, if any, of us went into the year predicting the pandemic and all that it brought. Far less significantly, it is equally unlikely that many people began last year by forecasting that the biggest asset management deals would all involve firms boosting their SMA propositions. Yet this is exactly what happened. Franklin Templeton acquired Legg Mason, a major player in the retail SMA market. Morgan Stanley snapped up Eaton Vance – parent of Parametric – a pioneer of direct indexing. And BlackRock bought Aperio, a firm focused on that same discipline. The buyers spent a combined $12.4bn on these deals, which highlights how important they believe these vehicles can become. With the BlackRock and Morgan Stanley deals in particular, their focus is on direct indexing, a style of investing that allows individual investors to customize an index to their specific needs, usually based on their tax situation and ethical outlook. Previously reserved for institutions and the ultra-high net worth, advances in technology mean that these strategies are becoming increasingly available to smaller investors. It could be the start of mass customization, a trend that would significantly disrupt asset management. This special report looks at the drivers behind the growth in SMAs, gets the inside track on the deals that may shape the market for years to come, gets deep into the weeds on how direct indexing works, and hears from three gatekeepers on how and why they use SMAs. I hope you find this guide useful.
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ALEX STEGER SMAs had a banner 2020, and an almost perfect confluence of factors means that their universe of investors is only going to expand from here on out. Some of the reasons behind the increased interest in the vehicle are qualities that SMAs have had since their inception, such as their flexibility and cost (above a minimum threshold). Others are old but have new impetus, such as their ability to offer customized tax treatment and personalized ESG investing. Then there are the newer drivers of attention. They are the wrapper of choice for direct indexing, and the technology needed for that investment approach has evolved to the point where the strategy is no longer the preserve of the ultra-rich and institutions. The combination of these trends, taken with others, such as the widespread use of model portfolios (largely structured as SMAs) and the ease of model delivery, means that interest in the vehicles is only set to accelerate further. At the end of 2020, there was $1.4tn in manager-traded or proprietary SMAs at the major wirehouses and broker-dealers, up 17.3% from $1.2tn from the year before, and 43.3% over two years, according to data from Cerulli Associates. These figures do not include SMAs used within unified managed account programs, which make up a further $695.4bn, up 26.3% from $550.8bn at the end of 2019, and up 48.6% over two years, according to Cerulli. One asset management executive, who asked to remain anonymous, estimated that industry-wide retail SMA assets had tripled since the 2008 financial crisis when they sat at around $500bn.
DEALS, DEALS, DEALS While market appreciation has played a part in SMAs’ asset growth, increased investor interest and inflows are real, a fact not lost on some of the largest asset managers around. Three of the biggest mergers and acquisitions of 2020 all involved buyers boosting their presence in the SMA market. Franklin Templeton’s $4.5bn acquisition of Legg Mason meant the San Mateo, California-based manager bought the third biggest player in retail SMAs and the biggest for model-delivered strategies, according to Cerulli data for the end of 2019. The only two firms with more retail SMA assets at the major wires and broker-dealers – Eaton Vance and BlackRock – were also involved in significant deals with SMAs at their hearts. Eaton Vance, which was the biggest player in retail SMAs at the end of 2020, per Cerulli data, was acquired by Morgan Stanley Investment Management for $7bn last October, and the buyer has been clear that SMAs, particularly those offered by Eaton Vance subsidiary Parametric, were a big reason for the deal. Parametric offers two popular SMA strategies: municipal bond ladders and direct indexing. The latter allows an investor to directly own the underlying stocks of an index and then customize it to fit their individual needs; for example, offsetting capital gains with losses to fit with their tax requirements or screening out specific stocks or sectors that do not align with their ethical or political outlook. At the time of the deal, Cetera CIO Gene Goldman told Citywire: ‘This [deal] makes sense for three reasons: Morgan Stanley gets a stronger foothold in ESG products, a significant strength of Eaton Vance; it gets more high-fee products, as Eaton Vance has a huge presence in liquid alternatives; and it gets access to a customized investment solution suite via the Parametric business at Eaton Vance.’ Goldman and Morgan Stanley were not the only ones alive to the opportunity in direct indexing. JP Morgan had bid unsuccessfully for Eaton Vance and would go on to buy 55ip, a startup providing technology to run tax-advantaged portfolios. More significantly, BlackRock bought Aperio for $1.05bn. Aperio offers tax-managed index strategies via SMAs and had around $36bn in assets under management as of the end of September 2020, which increased BlackRock’s SMA assets at the time by about 30% to $160bn.
SMAs have long offered customization, but technological advances mean the vehicle could now explode in popularity
GOOD TRAITS The fundamental tenets of SMAs did not change dramatically in the last year. They have always been bespoke, cost-effective, and tax-efficient. What has changed is their accessibility to investors, advisors, and asset managers.
OTHER FACTORS CONTRIBUTING TO DEMAND FOR SMAs INCLUDE: – wirehouse research teams increasingly asking for strategies to be available in multiple vehicles, not just mutual funds, spurring managers to launch more SMAs; – advisors increasingly outsourcing investment management, whether that be bond ladders that they might have run themselves 10 years ago, or complete client portfolios, leading to the rise of model portfolios, many of which are structured as SMAs; and – model portfolios being pushed within large wirehouses and broker-dealers as they seek to exert greater control over client investments, leading to increased offerings from the home offices and third-party managers.
The advent and increased adoption of model delivery mean that it is now easier for smaller managers with less infrastructure to run SMAs if asked. Less cumbersome advisor platforms and reporting tools allow wealth firms to build clients’ portfolios using a range of vehicles, not just mutual funds. And, most importantly, technology means tax and ESG customization can now be offered at scale, meaning the cost of access to this style of investing can come down, as can the previously high minimums needed to open such an account. As Tom O’Shea, research director for managed accounts at Cerulli, writes in a white paper published in January: ‘Several developments have created the opportunity to expand tax optimization to a broader set of clients, hopefully allowing the industry to deliver on the promise of tax customization through direct indexing. The disappearance of brokerage commissions eliminates the trading fees resulting from the high turnover of personalized indexes. In addition, the growing use of fractional shares allows lower balance accounts to hold the large number of securities necessary to track an index. The ever-increasing sophistication of algorithmic portfolio construction techniques is making it easier to manage direct index portfolios.’
‘Managed accounts have long been touted for their ability to be customized for the unique circumstances of each investor, particularly their tax situation. Yet decades after the emergence of this product, the industry should do more to create a personalized investment experience through managed accounts. The growing availability of fintech solutions that can support mass customization may help the financial services industry better deliver these benefits.’ The idea that custom strategies can be offered at scale is a key driver behind the 2020 deals. Speaking at the start of this year, BlackRock CEO Larry Fink said: ‘With technology, we now have better ability to customize indexes that have more sustainability structures. I believe that in the coming years, more of the large pension funds are only going to be investing in sustainable, customized indexes. I think you are going to see a huge movement away from the standard indexes. ‘This is one of my real big bets going forward...I would urge every investor to be focusing on what this all means.’ While Fink was focused on custom indexes’ ESG merits, their tax advantages are also very appealing to retail investors. And that only looks set to continue as the Biden administration plans to hike federal income and capital gains taxes for individuals. Add to this a long bull market, which means investors are sitting on a lot of gains, and the demand for tax-efficient strategies is likely to be heightened. According to Cerulli’s January white paper, asset managers see tax efficiency and ESG as equally large opportunities for SMAs (see earlier chart). ‘In order to get more consistent outcomes, home offices have been driving a lot of advisors into using model portfolios and home office portfolios,’ O’Shea told Citywire. He added that the wider shift in the industry from brokerage to advisory continued to drive the flows of assets to managed accounts, and thus SMAs. The short- and long-term trends are both headed in the same direction. As the unnamed asset management executive said: ‘The stars are aligned for SMAs these days. We are seeing growth and demand.’
Important information The use of environmental and social factors to exclude certain investments for non-financial reasons may limit market opportunities available to portfolios not using these criteria. Further, information used to evaluate environmental and social factors may not be readily available, complete or accurate, which could negatively impact the ability to apply environmental and social standards. Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. The opinions referenced above are those of the author as of April 27, 2021. These comments should not be construed as recommendations or an offer of any financial product. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations. Invesco does not offer tax advice. Please consult your tax professional for information regarding your own personal tax situation. Invesco Managed Accounts is an indirect, wholly owned subsidiary of Invesco Ltd.
If you’re a bond issuer preparing an environmental, social and governance (ESG) report for Eddie Bernhardt, don’t spend a lot of time choosing your cover photo: “I don’t need to see a pretty picture. I need to see the data.” Given Bernhardt’s role as the Head of Invesco Managed Accounts, it’s not surprising that data is his focus. But in an area like ESG — which has accelerated at an “unbelievable” pace — it can be difficult to cut through the noise. Getting the full story is more important than ever. “We hold issuers to a high bar. We look for robust transparency and data — the right data,” he says. “If you’re a school district, I need to know about child safety in your schools. If you’re a housing provider, it’s about access to low-income housing. If you’re a water utility, I need to know your environmental data.” “At the end of the day, our clients want to know that we understand every bond in their portfolio and why it’s there.” Customized fixed income strategies Thorough, ongoing credit analysis is the foundation of the approach Invesco Managed Accounts takes in all aspects of SMA construction, not just ESG research. IMA offers four investment grade strategies that can be personalized at inception to help meet investors’ tax, volatility, liquidity, and impact objectives. Across all strategies and portfolios, IMA employs an active top-down, bottom-up investment approach. This level of customization helps advisors build portfolios tailor-made for a client’s unique needs and preferences. Helping investors navigate an uncertain environment Advisors who are helping bond investors navigate their choices have been faced with a wide variety of questions and concerns. Everything from “How would higher taxes impact my portfolio?” to “How would an ESG approach impact my risk and return profile?” to “What happens if the Federal Reserve shifts its policy?” Taxes The question of taxes dominated the news in late April, thanks to reports that President Joe Biden planned to propose an increase in the top marginal income tax rate from 37% to 39.6% and a near doubling of taxes on capital gains to 39.6% for people earning more than $1 million. Any such increase would have to be approved by Congress, and a lot can change throughout that process, which means high-net-worth investors are faced with a high level of uncertainty. And in uncertain times, Bernhardt said, it’s important to concentrate on what you know and what you can control: “You know what the tax laws are right now, and you have a sense for what’s possible. So what do you do right now? Well, no one is proposing to take away the benefit of capital losses to offset gains. So if I were an advisor today, I’d be looking to be aligned with a manager that is astute in taking losses and limiting gains. It’s about ongoing tax management in this environment — harvesting losses whenever possible.” ESG Bernhardt remembers a time when the ESG conversation was mostly taking place in Europe and on the West Coast of the US. But today, it’s ubiquitous. “It used to be more on the fringes, but now it’s firmly in the mainstream,” he said. “Clients are more aware of the issues and realize that they don’t have to give up material returns in an ESG approach. The interest here is real.” When it comes to the performance of a fixed income portfolio, Bernhardt says there are two main levers that drive returns: “Returns are largely driven by duration and credit quality. So, for example, if you exclude oil and gas issues in an ESG approach, you can replace that exposure with other bonds that have similar spreads and credit quality. When you’re trying to figure out who to partner with, you don’t just want a manager that excludes coal but buys everything else. That’s a very low bar. It’s a lot more than that.” Invesco Managed Accounts offers four ways to customize a portfolio to an investor’s convictions — all built on a foundation of data-driven research. General Impact Overlay. This is the most popular approach among IMA’s impact offerings, Bernhardt said. It’s a broad-spectrum approach, where assets may be allocated to investments focused on the environment, education, housing, health care, social improvement, energy efficiency, and infrastructure improvements, among others. Environmental Issues Focus. This approach identifies investment opportunities with a high potential for positive impact in areas such as land, water, and energy conservation and seeks opportunities with good climate change profiles and low overall environmental impact. Gender Equity Focus. This approach filters investment opportunities using governance criteria such as women’s representation in leadership and senior management roles, including an evaluation of the number of board seats held by women and whether the board chair is female. Additionally, investment opportunities providing dedicated capital access programs, health care services, and educational opportunities for women are preferred. Faith-Driven Investing Focus. This approach, the newest offered by Invesco Managed Accounts, is designed to complement an investor’s personal values and ensure that their capital is not invested in a way that conflicts with their deeply held beliefs. Fed policy The potential unwinding of Federal Reserve policies has been a question for many investors. At its most recent policy meeting in March, the Federal Reserve left its expectation for the Fed Funds Rate unchanged for the next several years. This signaled to investors that despite an improving economy, the FOMC expects to keep the Fed Funds Rate at the zero bound and let the economy “run hot.” It also indicated that the Fed is not overly concerned about future levels of inflation running well above the targeted 2% average level. This lack of concern with future inflation triggered a rise in intermediate- and longer-term bond yields. Because inflation erodes the value of future interest payments, investors often push bond yields higher when they fear inflation is set to pick up. With the Fed’s firm commitment to easy monetary policies, investors were quick to price in higher inflation. This led many clients to question how far the sell-off could go. “This is a difficult question to answer as the level and direction of interest rate movements are based on many factors and are notoriously difficult to predict,” says Senior Portfolio Manager Tim Benzel. “However, bond bulls point to a few reasons as to why we are closer to the end than the beginning of the 2021 sell-off, including good news surrounding vaccine distribution and fiscal stimulus now being well understood by investors. Also cited are market-based measures of inflation expectations, which call for higher inflation over the next five years than the subsequent five years. Essentially, the market is predicting that inflation will slow during the back half of the decade after accelerating for the next few years.” Benzel noted that the increase in rates was a welcome event as it gave Invesco Managed Accounts the opportunity to reinvest interest payments and maturities into new bonds with more attractive yields. “We are also encouraged that the increase in government bond yields hasn’t had a major impact on other sectors of the market such as munis and corporates,” he said. The evolution of the virus and governments’ abilities to implement large-scale vaccination programs should continue to shape the economic environment in the first half of 2021, determining which sectors, industries, companies, and municipalities will be winners and losers. While pockets of short-term volatility are possible, the support from various central banks cannot be ignored, which makes any sort of significant retracement to March levels unlikely, Benzel says. As for the second half of the year, he expects to see a marked improvement in the economy, specifically for various service sectors, as lockdowns end and pent-up demand for travel and leisure is turned loose. During this time, Benzel believes the Fed will have a difficult task: “With the economy likely on more solid footing, attention will turn to the eventual unwinding of the support programs that have been put in place. Doing so without creating financial market disruption will be key, and, as we saw in 2013 with the infamous ‘taper tantrum,’ this will not be an easy task. Therefore, we believe the central downside risk to markets in 2021 is a communication error by the Fed or a pullback of fiscal support.” For bond investors, Benzel says the riskier sectors of the market are likely to be supported by the yield hunt from domestic and foreign investors, as sovereign bond yields trade at historically low levels. This makes strong credit research imperative, he says: “In our view, value can be added by finding bonds that are trading at reasonable valuations, are positioned to benefit from the global search for yield, and are backed by credits with the fundamental strength to survive the next few quarters.”
Invesco Managed Accounts personalizes fixed income portfolios to help meet investors’ tax, volatility, liquidity, and impact objectives.
“It's about ongoing tax management in this environment -- harvesting losses wherever possible”
“When you're trying to figure out who to partner with, you don't just want a manager that excludes coal but buys everything else. That's a very low bar. ESG investing is a lot more than that”
“With the economy likely on more solid footing, attentionwill turn to the eventual unwinding of the support programs that have been put in place”
NICOLE PIPER Direct indexing was once considered a niche part of the industry. It was practiced by smaller firms for specific types of clients. This changed in 2020 as some industry giants sat up, took notice, and got out their checkbooks. Last year alone, four of the biggest fund managers acquired shops specializing in direct indexed strategies or the technology behind this approach to investing. Morgan Stanley Investment Management acquired Parametric via its $7bn purchase of Eaton Vance, BlackRock bought Aperio for $1bn, JP Morgan Asset Management purchased 55ip, and Goldman Sachs Asset Management bought Folio. ‘This is not niche,’ said Dan Simkowitz, head of investment management at Morgan Stanley, who made it clear that Parametric’s SMA offering was a major factor in the asset manager’s acquisition decision. ‘This is core to our secular view of the asset and wealth management market over the next 10 or 15 years: Customization is going to be a pillar of growth and a pillar of value to clients.’ Simkowitz told Citywire that although some institutional or sophisticated retail investors have been focused on direct indexing via SMAs for some time, its move into the mainstream has been driven by two recent trends: ESG and tax benefits. ‘You have these two big secular interests that are going on that are perfect for customization: one being tax volatility and the second one being sustainability. These things line up perfectly around customization,’ he said. Simkowitz is not alone in holding this view. Increased tax awareness, the rise of values-based investing, and technological innovation have combined to catapult direct indexing, an approach that by default can only be delivered via an SMA, to the forefront of the asset management industry.
The biggest asset managers are all in on direct index-based SMAs as they race to be at the forefront of the industry’s next giant leap
TACKLING TAX Direct indexing allows investors to conduct tax-loss harvesting, something that may be front-of-mind as high net worth individuals anticipate higher taxes under the Biden administration, according to Ben Johnson, director of global ETF research at Morningstar. ‘Over time, it can reduce the level of concentration in a way that’s as tax efficient as possible,’ he said. Greg Weiss, head of BlackRock’s managed accounts business, agreed. ‘Taxes have become so prominent in what advisors and clients are facing, and ultimately, the SMA wrapper enables those clients to personalize these portfolios for their tax needs,’ he said. ‘If you have gains elsewhere in your portfolio, you could use these strategies to harvest losses to offset those gains elsewhere.’ He added that this was the case for all SMAs, given that the vehicle allows investors to directly own holdings in a strategy run just for them rather than buying shares in a pooled mutual fund.
‘One of the hallmarks of the SMA has always been the ability to customize for taxes,’ Weiss said. ‘That has been a time-tested hallmark of the SMA, and as tax rates increase the demand just increases as well.’ And tax rates are certainly front-of-mind for many investors in 2021. The Biden administration has set out plans to raise various taxes. This includes upping the top individual federal income tax rate from 37% to 39.6% and raising the top tax rate on long-term capital gains to 39.6% from 20% for people earning more than $1m. Brian Langstraat, head of Parametric, said the Biden administration’s tax plans ‘absolutely’ impacted the popularity of SMAs, particularly direct index strategies. ‘We at Parametric have run this strategy through lots and lots of market cycles and tax regimes over the decades, and each time there’s an increase in capital gains taxes and increased complexity around capital gains tax, there’s at least a marginal – but significant for us – interest in this type of investing,’ he said. ‘I think there will be an increase in capital gains taxes for wealthy investors – who knows exactly how much – but if you put that into the environment that we’re sitting in, which is already sensitive to taxes, indexing, and ESG, it has a compounding effect.’
ADDING VALUES To Langstraat’s point, and as is well-documented, investors today are increasingly concerned about the impact their investments have beyond just generating returns, spurring a flood of flows to ESG strategies. The problem is not all investors share the same idea about what is and is not ESG. This is a problem in a mutual fund, where all investors must buy into the same strategy. But
customized SMAs allow an investor to handpick their sustainable investments without worrying about stocks that aren’t aligned with their values getting in the way. Johnson emphasized the ease with which custom index investments can help investors align their money with their values, something that isn’t so easy with a mutual fund or ETF. ‘It’s difficult to do, at scale, with an off-the-shelf investment product, because that fund – be it an index fund or be it a discretionary active portfolio – is going to express a very specific view of what your E, S, and G mean, and that might not always directly align with investors at large,’ he said. One firm that sought to cash in on the compatibility of direct indexing and ESG investments is Ethic. ‘Separate accounts are just more aligned with that type of advisor, so that’s where we’ve really won the most over the past few years,’ said Alex Laipple, head of business development at Ethic. Ethic CEO Doug Scott, meanwhile, told Citywire that the direct indexing market is so hot lately because, for one, it is more accessible than ever before. ‘Major custodians are creating an opportunity where it’s now economic to be able to do more trading, more personalization, in a way that if you go back a couple of years, it was more prohibitive,’ Scott said. While Ethic was not part of 2020’s M&A frenzy, it still made headlines. In March, the firm raised $29m in a series B funding round, which included Fidelity Investments and Ashton Kutcher’s Sound Ventures. Both firms had previously participated in Ethic’s $13m Series A round, which was led by venture capital firm Nyca Partners in 2019. Between the Series A and B rounds, Ethic had grown assets under management by 10 times. BlackRock has also taken steps as a firm to position itself as a leader in sustainable investing, and its acquisition of Aperio, Weiss said, will only accelerate this objective. ‘Many high net worth and ultra-high net worth investors want to tailor their values to their portfolios in their own way, and Aperio does really well in providing either ESG-predefined strategies, incorporating ESG tilts and/or exclusions, or allowing advisors and investors to ultimately create their own [strategy] using various building blocks like faith-based, social, environmental, or even by making certain exclusions like fossil fuels, nuclear power, animal testing, or finally with shareholder advocacy,’ he said. TALKING TECH One of the biggest components of direct index investing, which creates bespoke strategies at scale, is the reliance it has on technology, bringing software and coding to a role traditionally conducted by an advisor. ‘I would argue what direct indexing is evolving into is really just software, so it’s software that tries to understand who this investor is, what are their unique needs, what are their unique preferences, and how do we build, down to the individual security level, a portfolio that understands their circumstances and meets their needs,’ Johnson said. According to Simkowitz, technological advances will help democratize access to these strategies, and by extension, SMAs. ‘Digital, cloud, automation, machine learning – all of those are going to help get minimums a little bit lower and get more clients interested, which is good because the separately managed customized account is a great, great value provider to clients, so it makes industrial sense,’ he said. ‘And obviously, all of this fits extremely well into a fee-based advisory context.’
Scott said the advance in tech can open up resources and help expand the fee-based advisor model. Weiss also flagged this shift, noting that fee-based advisory assets have grown in the past 10 years from 20% of investable assets to 50% of all wealth management assets. ‘The shift to zero brokerage […] is also creating an opportunity where it’s now economic to be able to be doing more trading, more personalization, in a way that if you go back a couple of years, it was more prohibitive,’ Scott said. To Simkowitz, the technical nature of the vehicle and its accessibility are both reasons for the big firms to move into the space. ‘I think it’s the large firms that are going to be the ones that have the capabilities, technology, and resources [required], because it’s not just a simple investment algorithm on the back end. Customization requires a lot of education for financial advisors and end clients,’ he said. ‘It requires a lot of moving parts.’
THE BOTTOM LINE The reasons the industry’s biggest asset managers all got into direct indexing aside, firms are mixed on the way they can operate independently or as a group. Parametric’s Langstraat said the firm’s initial partnership with Eaton Vance and its subsequent acquisition by Morgan Stanley not only gave it the infrastructure and distribution capabilities of a large firm but also a breadth of other investments to complement the 100,000 fully customized individual SMAs Parametric offers. ‘It was clear to us really early on in the business cycle that we would realize our potential in partnership with other aspects of asset management: the investment vehicles that we could avail ourselves of, the intellectual property, the technology, regulatory, and compliance,’ Langstraat said. However, Ethic’s Scott said standing alone will differentiate his firm from the other acquisition targets. Unlike many of the other firms in this space, Ethic is planning to stay independent. Scott said it has no plans to shop itself out for a merger or acquisition anytime soon.
‘In light of consolidation in the last year, for us to be sort of now the preeminent independent direct indexing sustainable solution is really important for us,’ he said. To Morningstar’s Johnson, however, who sits above the M&A fray as an analyst, while these acquisitions may not drive the asset managers’ business models in terms of assets, they are making an investment into another piece of the investment puzzle. ‘They’re just trying to orient themselves in a way that offers breadth of choice to their end clients,’ he said. ‘It’s one piece of the puzzle, and I think certainly if you look at the direction of travel within the industry, it’s towards mass customization, so to have an established capability in your broader suite of offerings make sense.’
BlackRock has also taken steps as a firm to position itself as a leader in sustainable investing, and its acquisition of Aperio, Weiss said, will only accelerate this objective. ‘Many high net worth and ultra-high net worth investors want to tailor their values to their portfolios in their own way, and Aperio does really well in providing either ESG-predefined strategies, incorporating ESG tilts and/or exclusions, or allowing advisors and investors to ultimately create their own [strategy] using various building blocks like faith-based, social, environmental, or even by making certain exclusions like fossil fuels, nuclear power, animal testing, or finally with shareholder advocacy,’ he said. TALKING TECH To Langstraat’s point, and as is well-documented, investors today are increasingly concerned about the impact their investments have beyond just generating returns, spurring a flood of flows to ESG strategies. The problem is not all investors share the same idea about what is and is not ESG. This is a problem in a mutual fund, where all investors must buy into the same strategy. But customized SMAs allow an investor to handpick their sustainable investments without worrying about stocks that aren’t aligned with their values getting in the way. Johnson emphasized the ease with which custom index investments can help investors align their money with their values, something that isn’t so easy with a mutual fund or ETF. ‘It’s difficult to do, at scale, with an off-the-shelf investment product, because that fund – be it an index fund or be it a discretionary active portfolio – is going to express a very specific view of what your E, S, and G mean, and that might not always directly align with investors at large,’ he said. One firm that sought to cash in on the compatibility of direct indexing and ESG investments is Ethic. ‘Separate accounts are just more aligned with that type of advisor, so that’s where we’ve really won the most over the past few years,’ said Alex Laipple, head of business development at Ethic. Ethic CEO Doug Scott, meanwhile, told Citywire that the direct indexing market is so hot lately because, for one, it is more accessible than ever before. ‘Major custodians are creating an opportunity where it’s now economic to be able to do more trading, more personalization, in a way that if you go back a couple of years, it was more prohibitive,’ Scott said. While Ethic was not part of 2020’s M&A frenzy, it still made headlines. In March, the firm raised $29m in a series B funding round, which included Fidelity Investments and Ashton Kutcher’s Sound Ventures. Both firms had previously participated in Ethic’s $13m Series A round, which was led by venture capital firm Nyca Partners in 2019. Between the Series A and B rounds, Ethic had grown assets under management by 10 times. One of the biggest components of direct index investing, which creates bespoke strategies at scale, is the reliance it has on technology, bringing software and coding to a role traditionally conducted by an advisor. ‘I would argue what direct indexing is evolving into is really just software, so it’s software that tries to understand who this investor is, what are their unique needs, what are their unique preferences, and how do we build, down to the individual security level, a portfolio that understands their circumstances and meets their needs,’ Johnson said. According to Simkowitz, technological advances will help democratize access to these strategies, and by extension, SMAs. ‘Digital, cloud, automation, machine learning – all of those are going to help get minimums a little bit lower and get more clients interested, which is good because the separately managed customized account is a great, great value provider to clients, so it makes industrial sense,’ he said. ‘And obviously, all of this fits extremely well into a fee-based advisory context.’
As advisors and wealth managers look for ways to differentiate what they offer, direct indexing has gained in popularity. Raina Oberoi, Head of Index Solutions Research for the Americas at MSCI and Paul Riccardella, Executive Director, Head of Americas Index Wealth Advisory Team at MSCI sat down for a Q&A with Citywire to discuss how to make the most of direct indexing in a portfolio. CW: Direct indexing has increased quite substantially in popularity in the last year. To what do you attribute this boom in the direct indexing marketplace? PR: There are really four distinct trends driving the boom in direct indexing. The first is the relative benefits of indexed investing. If you use the ETF industry as a proxy for indexed investing, it’s hard to discount the popularity of this investment approach over the past decade. The second factor is technological advances. That includes breaking down the barriers to supporting indexed SMAs in scale, and fractional shares among other innovations. The third factor is merger and acquisition activity in the space, which has significantly increased the size of a number of firms that rely heavily on indexing. And finally, the ability of indexes to reflect the unique needs of investors. Indexes can offer a high level of customization, making them a powerful tool for investors to craft individualized portfolios. CW: What types of organizations are looking at direct indexing? PR: Providers of direct indexing generally fit into three groups - asset managers, wealth managers, and technology providers. Asset managers see indexed investing as an efficient and scalable means by which they can deliver their strategies to the market. Wealth managers who want to insource some of their investment activities like indexed investing for the ease of use. Wealth managers can launch their own direct indexing platform and stand out from their peers. Lastly, technology providers can add direct indexing capabilities to their platforms to expand their client base. CW: What index content is most popular right now? PR: At MSCI, we see very strong demand for index customization based on our ESG and climate research. Integrating these considerations into portfolios is front of mind for a large and growing number of investors . Because ESG and climate considerations are relatively new there is still a lot of innovation in the space, which appeals to investors who have certain ideas about ESG or climate, as well as managers that want to differentiate their offerings. We also see strong interest in customization indexes based on our factor and thematic exposures. Many investors like the idea of customizing their beta exposures and taking advantage of transformative megatrends. When you consider all of this flexibility to manage different types of exposures, you can get very specific with direct indexing. CW: What are the benefits of optimization in a direct indexing investment process? Do you have any thoughts on how optimization can be used to build tax-efficient portfolios? RO: Optimization is generally rules-based and scalable, so it can be an efficient way to build a portfolio. The benefit of optimization with direct indexing is that you can easily incorporate your objective and constraints. If you’re a value stock picker for example but want to limit turnover and don’t want too many stocks in your portfolio, optimization can help you achieve all these goals. That’s really what has attracted a lot of investors to direct indexing as it has the ability to set up a strategy very easily. You can also optimize for issues like tax efficiency, which can have a meaningful impact on your portfolio returns. Building tax-efficient portfolios can actually be quite challenging if you’re managing the taxes manually and inputting that data, which is what a lot of advisors end up doing. Tax concerns can often be address as part of the optimization process. Optimization can help you efficiently harvest losses and offset them against net gains in the portfolio so that your net tax is zero. CW: What are the benefits of tax-aware strategies and what are some considerations that investors should keep in mind why building such portfolios? RO: Based on our research, U.S. tax-aware strategies have outperformed their tax-agnostic counterparts historically. Optimization allows for the employment of various tax strategies that aim to reduce or offset losses against portfolio gains. The turnover historically of such strategies tends to be less than their tax-agnostic counterparts as the optimizer does not trade if it sees that it is going to incur high taxes. In addition it is also able to maintain minimum tracking error and similar risk as those of the underlying tax-agnostic strategy. The goal is to achieve tax efficiency without detracting from the original strategy. CW: MSCI’s CEO and Global Head of Index have both talked recently about the concept of “an index for every portfolio.” What does that mean for direct indexing and are there any tools you are working on to power that vision? PR: In response to growing demand from our clients to customize index exposures, and the range of customization available across ESG & climate, factors and thematic, we are building software tools that empower clients. Later this year, investors will be able to build, test and analyze custom indexes on the fly through an application. By simulating the performance of different index-based strategies, investors can decide if they want to take action by licensing the index or if they need to continue refining its exposures. Fine-tuning of exposures using MSCI’s application offers a range of advantages relative to other testing methods because of the increased precision and data quality standards offered in MSCI’s custom index production environment.
Paul Riccardella
Raina Oberoi
Direct indexing continues to grow in popularity with asset managers and wealth managers. Optimizing for certain outcomes can add value to direct indexing in a portfolio.
Executive Director, Head of Wealth Advisory Team
Managing Director, Head of Equity Solutions Research - Americas
“At MSCI, we see very strong demand for index customization based on our ESG and climate research”
ALEX ROSENBERG
Patrick O’Shaughnessy, CEO of O’Shaughnessy Asset Management, gives a glimpse of the future of investor customization
To learn more about some of the innovative ways SMAs are being used today – and to get a sneak peek at the applications that may be added in the future – we talked to Patrick O’Shaughnessy, CEO of O’Shaughnessy Asset Management. You might also know him as the host of the popular Invest Like The Best podcast and the son of quant investing godfather Jim O’Shaughnessy. In this interview, O’Shaughnessy speaks about his company’s software-centric investing service, Canvas, which is a pioneer of ‘custom indexing.’
Citywire: What does Canvas do? Patrick O’Shaughnessy: Canvas is the first custom indexing platform. Custom indexing is software that allows advisors to design and implement unique strategies in separate accounts for their clients. A lot of people have heard about direct indexing, which is where you hire a manager to invest in the underlying securities in, say, the S&P 500, and they do tax-loss harvesting, which is a benefit to the end investor. Custom indexing is the natural next leg of the progression, where not only can you invest in indexes, but you can also invest in other factors or other active strategies that are a means to a certain end. That end could be more income or more downside protection or different kinds of tax advantages. For example, perhaps you’re trying to diversify away from a single-stock position in a tax-friendly way, or trying to transition between two strategies in a tax-friendly way. So it basically combines quantitative research with software and turns the power over to the advisor to be able to design a custom strategy for every one of their clients. CW: Tell us about the term ‘custom indexing.’ PO: We spent a year trying to figure out what to call this, because I’m a big believer in positioning and the importance of names. We eventually coined ‘custom indexing,’ and the reason we like it so much is, obviously, everyone’s familiar with indexing. Most people use this to index – meaning that about 75% of the assets we manage are indexed to one of the major MSCI, S&P or Russell indexes. So it is indexing in some way, and ‘custom’ is the other word that we think is the differentiator here. Because unless you have listing software and unless you’re great at quant research, you can’t offer true customization. Incidentally, we market test these things; we say them in meetings and see if people say them back to us or not. We tried ‘investing operating system’; we tried ‘investment software services.’ We tried all this different stuff and no one ever said any of those things back to us. But we said ‘custom indexing’ once and everyone was talking about custom indexing. CW: What are the benefits of customization? PO: I should mention that we don’t require people to customize. They could just do direct indexing on the platform if that’s what they wanted. So, the demand reveals itself. Do people care about customization or not? Well, we just crossed 750 accounts, close to about a billion and a half of assets in those accounts, and 80% of the accounts have completely custom settings. So, we’re not forcing that usage, but people deeply use the custom feature. In other words, this isn’t bullshit – people actually want the customization. What are the dimensions that they care the most about? The first, by far, is taxes. And there are all of these interesting tax preferences or constraints that crop up. Let me give an example of something we’re dealing with right now. Let’s say someone has $10m of Coinbase stock and a couple of million in cash, and they want to start with a direct index and then pair losses against selling gains in Coinbase and glide-path their way out of it. The second is what I would call factor customization. So, this is the ability to say, for instance, ‘I want value in the portfolio.’ The third category is risk and ESG, and I’ll bunch those together. So, risk might be: I work in an asset management firm, I don’t want to own any more capital market companies, because I’m personally exposed through my human capital to that industry and I don’t need more of that exposure. And then ESG is obvious. We have this big menu of issues that people have come to us saying, ‘We want to adjust for X, Y or Z.’ I think it’s more than 50 issues now that we’ve built out. CW: Tell us more about the ESG capabilities. PO: Well, you could use ESG tools to avoid emissions or overweight companies with the lowest emissions that seem to have adjusted their businesses in the best ways for this. So, it’s both negative screening and positive screening in ESG. That’s only 15% to 20% of our accounts, but for those that use that, it’s probably the most important feature. CW: How does it actually work from the RIA’s perspective? PO: We work with all the major custodians, and it’s all separate accounts. So, each investor opens an account or multiple accounts. We have discretion over those accounts. So we do all the trading, and now we also do all the reporting. You have to have $250,000 per account to open a Canvas account. There are pricing tiers, and for any account between $250,000 and $1m, it’s 35 basis points as a starting point, and then once you get to a $1m account or higher, it’s 20 basis points. These rates are very competitive with the direct indexers out there. CW: Do you see that account minimum coming down eventually? PO: The minimum will definitely fall over time. Trading costs are zero or going to zero, if they’re not there yet. Fractional shares are basically there and getting easier and will effectively be frictionless. And the operational costs are falling. So as those three things fall close to zero, the minimums will fall for custom indexing, and at some point, anyone will be able to do this. You’ll be able to do this in a $2,000 robo-account. That’s years away, to be clear, but that’s where this will all go. Technology makes that inevitable. CW: Could advisors get cut out of the equation, then? PO: I think the advisors are the key ingredient in this whole thing, because if you think about this, right now it’s a very powerful, but decently complex, cockpit. The advisors are the ones that are at the helm here – understanding planning and the circumstances of each client and then using a platform to create an investment strategy that fulfills the goals and needs of the investor. Maybe there will eventually be a direct solution that does that; maybe it will be powered by Canvas, I don’t know. But I do know from deep experience, that especially at a certain asset level, people want an advisor. Look at it this way – none of the robo-advisor technology has dinged the advisor business at all. Not only has it not dinged their assets, it hasn’t even dinged their revenue. Their revenue yield on assets has been exactly the same. So I don’t think that advisors are threatened here. Technology doesn’t seem to have disrupted them in the past. People want human advice. CW: Where is Canvas heading from here? PO: So we’ll grow in two ways. The first is horizontal expansion. That means that now you can do the same things you did in equities in crypto, in fixed income, in options, maybe in alternatives – although that would be tricky. So the ability to customize and have access to great strategies in other asset classes is the obvious next step. The other exciting one, which is probably a bit further away, is what I call vertical expansion, and that is the way in which our customers access Canvas. So right now, you would go on a website, you would get a login, you have two-factor authentication, just like any web-based software you’ve ever used. I think in the future, many will access us programmatically. So let’s say an advisor wants to build their own app for a client and let the client directly interact with the app. Canvas would power that app. We wouldn’t develop the app, but we would provide the tools, the APIs that would allow other developers to build other software on top of Canvas. So programmatic access is, I think, the other exciting kind of expansion that you’ll see from us in the years to come. CW: How would that work in practice? PO: In the same way that you don’t have to set up a server in your basement anymore – you just hire Amazon Web Services. You could hire Canvas in the same way. It would be a specifically software-developer-faced way of interfacing with Canvas because I think advisors, in five, 10 years, are going to have their own software. It’s going to be table stakes. If I’m a fancy RIA serving ultra-wealthy clients, I’m probably going to have some mobile or other sort of digital interface that’s customized. And I think Canvas can power a lot of that ecosystem.
To learn more about some of the innovative ways SMAs are being used today – and to get a sneak peek at the applications that may be added in the future – we talked to Patrick O’Shaughnessy, CEO of O’Shaughnessy Asset Management. You might also know him as the host of the popular Invest Like The Best podcast and the son of quant investing godfather Jim O’Shaughnessy. In this interview, O’Shaughnessy speaks about his company’s software-centric investing service, Canvas, which is a pioneer of ‘custom indexing.’ Citywire: What does Canvas do? Patrick O’Shaughnessy: Canvas is the first custom indexing platform. Custom indexing is software that allows advisors to design and implement unique strategies in separate accounts for their clients. A lot of people have heard about direct indexing, which is where you hire a manager to invest in the underlying securities in, say, the S&P 500, and they do tax-loss harvesting, which is a benefit to the end investor. Custom indexing is the natural next leg of the progression, where not only can you invest in indexes, but you can also invest in other factors or other active strategies that are a means to a certain end. That end could be more income or more downside protection or different kinds of tax advantages. For example, perhaps you’re trying to diversify away from a single-stock position in a tax-friendly way, or trying to transition between two strategies in a tax-friendly way. So it basically combines quantitative research with software and turns the power over to the advisor to be able to design a custom strategy for every one of their clients. CW: Tell us about the term ‘custom indexing.’ PO: We spent a year trying to figure out what to call this, because I’m a big believer in positioning and the importance of names. We eventually coined ‘custom indexing,’ and the reason we like it so much is, obviously, everyone’s familiar with indexing. Most people use this to index – meaning that about 75% of the assets we manage are indexed to one of the major MSCI, S&P or Russell indexes. So it is indexing in some way, and ‘custom’ is the other word that we think is the differentiator here. Because unless you have listing software and unless you’re great at quant research, you can’t offer true customization. Incidentally, we market test these things; we say them in meetings and see if people say them back to us or not. We tried ‘investing operating system’; we tried ‘investment software services.’ We tried all this different stuff and no one ever said any of those things back to us. But we said ‘custom indexing’ once and everyone was talking about custom indexing. CW: What are the benefits of customization? PO: I should mention that we don’t require people to customize. They could just do direct indexing on the platform if that’s what they wanted. So, the demand reveals itself. Do people care about customization or not? Well, we just crossed 750 accounts, close to about a billion and a half of assets in those accounts, and 80% of the accounts have completely custom settings. So, we’re not forcing that usage, but people deeply use the custom feature. In other words, this isn’t bullshit – people actually want the customization. What are the dimensions that they care the most about? The first, by far, is taxes. And there are all of these interesting tax preferences or constraints that crop up. Let me give an example of something we’re dealing with right now. Let’s say someone has $10m of Coinbase stock and a couple of million in cash, and they want to start with a direct index and then pair losses against selling gains in Coinbase and glide-path their way out of it. The second is what I would call factor customization. So, this is the ability to say, for instance, ‘I want value in the portfolio.’ The third category is risk and ESG, and I’ll bunch those together. So, risk might be: I work in an asset management firm, I don’t want to own any more capital market companies, because I’m personally exposed through my human capital to that industry and I don’t need more of that exposure. And then ESG is obvious. We have this big menu of issues that people have come to us saying, ‘We want to adjust for X, Y or Z.’ I think it’s more than 50 issues now that we’ve built out. CW: Tell us more about the ESG capabilities. PO: Well, you could use ESG tools to avoid emissions or overweight companies with the lowest emissions that seem to have adjusted their businesses in the best ways for this. So, it’s both negative screening and positive screening in ESG. That’s only 15% to 20% of our accounts, but for those that use that, it’s probably the most important feature. CW: How does it actually work from the RIA’s perspective? PO: We work with all the major custodians, and it’s all separate accounts. So, each investor opens an account or multiple accounts. We have discretion over those accounts. So we do all the trading, and now we also do all the reporting. You have to have $250,000 per account to open a Canvas account. There are pricing tiers, and for any account between $250,000 and $1m, it’s 35 basis points as a starting point, and then once you get to a $1m account or higher, it’s 20 basis points. These rates are very competitive with the direct indexers out there. CW: Do you see that account minimum coming down eventually? PO: The minimum will definitely fall over time. Trading costs are zero or going to zero, if they’re not there yet. Fractional shares are basically there and getting easier and will effectively be frictionless. And the operational costs are falling. So as those three things fall close to zero, the minimums will fall for custom indexing, and at some point, anyone will be able to do this. You’ll be able to do this in a $2,000 robo-account. That’s years away, to be clear, but that’s where this will all go. Technology makes that inevitable. CW: Could advisors get cut out of the equation, then? PO: I think the advisors are the key ingredient in this whole thing, because if you think about this, right now it’s a very powerful, but decently complex, cockpit. The advisors are the ones that are at the helm here – understanding planning and the circumstances of each client and then using a platform to create an investment strategy that fulfills the goals and needs of the investor. Maybe there will eventually be a direct solution that does that; maybe it will be powered by Canvas, I don’t know. But I do know from deep experience, that especially at a certain asset level, people want an advisor. Look at it this way – none of the robo-advisor technology has dinged the advisor business at all. Not only has it not dinged their assets, it hasn’t even dinged their revenue. Their revenue yield on assets has been exactly the same. So I don’t think that advisors are threatened here. Technology doesn’t seem to have disrupted them in the past. People want human advice. CW: Where is Canvas heading from here? PO: So we’ll grow in two ways. The first is horizontal expansion. That means that now you can do the same things you did in equities in crypto, in fixed income, in options, maybe in alternatives – although that would be tricky. So the ability to customize and have access to great strategies in other asset classes is the obvious next step. The other exciting one, which is probably a bit further away, is what I call vertical expansion, and that is the way in which our customers access Canvas. So right now, you would go on a website, you would get a login, you have two-factor authentication, just like any web-based software you’ve ever used. I think in the future, many will access us programmatically. So let’s say an advisor wants to build their own app for a client and let the client directly interact with the app. Canvas would power that app. We wouldn’t develop the app, but we would provide the tools, the APIs that would allow other developers to build other software on top of Canvas. So programmatic access is, I think, the other exciting kind of expansion that you’ll see from us in the years to come. CW: How would that work in practice? PO: In the same way that you don’t have to set up a server in your basement anymore – you just hire Amazon Web Services. You could hire Canvas in the same way. It would be a specifically software-developer-faced way of interfacing with Canvas because I think advisors, in five, 10 years, are going to have their own software. It’s going to be table stakes. If I’m a fancy RIA serving ultra-wealthy clients, I’m probably going to have some mobile or other sort of digital interface that’s customized. And I think Canvas can power a lot of that ecosystem.
For Financial Professional Use Only. This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market and other conditions. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Natixis Investment Managers or any of its affiliates. This information should not be considered a recommendation to buy or sell any security. There can be no assurance that developments will transpire as forecasted. Actual results may vary. Past performance is no guarantee of future results. All investing involves risk, including possible loss of principal. Please read the risks associated with each investment prior to investing. Detailed discussions of each investment’s risks are included in Part 2A of each firm’s respective Form ADV. The investments highlighted in this presentation may be subject to certain additional risks. Performance data quoted represents past performance and is no guarantee of future results. Indexes are unmanaged, do not incur fees, and include reinvestment of dividends and interest income, if any. It is not possible to invest in an index. Future tax liabilities may be higher in an SMA that uses loss harvesting because it may have larger unrealized capital gains. Tax law and tax rate changes may also impact the relative value of index mutual funds, ETFs, and SMAs. Natixis Advisors, L.P. does not provide tax advice. Please consult with your financial advisor or tax professional. Natixis Advisors, L.P. provides advisory services through its divisions Active Index Advisors® and Managed Portfolio Advisors®. Advisory services are generally provided with the assistance of model portfolio providers, some of which are affiliates of Natixis Investment Managers, LLC. Natixis Distribution, L.P. is a limited purpose broker-dealer and the distributor of various registered investment companies for which advisory services are provided by affiliates of Natixis Investment Managers. Adtrax # 3563385.1.1
Proposed changes to the US tax structure by the Biden administration should not be overlooked by financial professionals in 2021, especially those managing portfolios for high net worth individuals. While there is still a lot of uncertainty about what specific changes to the tax code are likely to make it through the legislative process, Curt Overway, CFA®, President and Portfolio Manager of Managed Portfolio Advisors® and Active Index Advisors®, believes preparing high income earning clients’ portfolios now for the inevitable rise in taxes is a smart move. “Ongoing budget deficits and recent and expected stimulus spending have led to very high levels of government debt, both on an absolute level and as a percentage of GDP. In fact, debt as a percentage of GDP is currently well above its previous peak at the end of WWII,” says Overway. Therefore, he believes it is more likely that income and estate taxes will increase than they will decrease. Here are some of President Biden’s proposals thus far that may impact after-tax investment returns: - Increasing the top income tax rate back to 39.6% for households earning over $400,000 - Taxing capital gains at the ordinary income tax rate for households earning over $1 million - Taxing unrealized capital gains at death, i.e. eliminating the step up in basis - Increasing the estate tax rate and lowering the threshold where it applies - Increasing the corporate income tax rate to 28% and other changes to corporate taxes “The impact of these changes would be most pronounced on households earning over $1 million. But there could also be a more modest impact on households earning between $400,000 and $1 million,” says Overway, adding “Should Biden’s proposal to tax capital gains at ordinary income rates go into effect, that would indeed be a dramatic change in the tax rate for those affected, increasing from 20% to 39.6%. Plus the additional 3.8% Net Investment Income Tax, which would apply to both.” How might markets react? Could capital gains and/or corporate tax hikes trigger selling of appreciated securities as investors look to take advantage of lower tax rates before the new, higher rates go into effect? “Certainly, but the overall impact on the market should not be overestimated. First, based on the current proposal, this would only apply to households with more than $1 million in income and would only apply to any taxable assets,” says Overway. Secondly, for many of these individuals, he believes it may still make sense to continue to hold investments and defer the realization of the gain and the associated tax liability. For example, if there is no need to liquidate that investment in the near term, it may make sense to defer that sale. The applicable tax rate could again be lower at that point, due to either future changes to the tax code or a change in the taxpayer’s situation (e.g. income may be lower in retirement).
LEARN TECHNIQUES FOR MITIGATING TAX COSTS IN INVESTING For an in-depth understanding of managing taxable investments, Natixis Investment Managers offers a CE-accredited course to financial professionals. Techniques for Mitigating Tax Costs in Investing walks you through why and how tax management should be made at every step of the financial, portfolio construction, and management process. Upon completion, you will be able to: - Discuss how taxes may impact investment portfolios - Understand potential tax-related legislation and implications for planning - Explain the factors that drive tax efficiency - Compare and contrast common investment vehicles - Describe techniques that can be employed to mitigate the impact of taxes and enhance clients’ after-tax returns Call your Natixis representative or visit im.natixis.com for continuing education details.
Portfolio tax impact analysis To assess the potential impact of the proposed changes on investment returns, we’ve retroactively applied the proposed tax rates to two types of portfolios: 1. Actively managed equity-oriented portfolios and 2. Composite of S&P 500 direct index portfolios. The current results in each chart represent the returns after taxes, based on the highest federal tax rates currently in place. The $400k-$1M scenarios show what the returns after taxes would have been for households in this new income bracket under Biden’s proposal (i.e. increasing the ordinary income rate from 37 to 39.6%), and the $1M+ scenarios reflect the higher rates (higher top federal tax rate of 39.6% and capital gains taxed at ordinary income rate) that would apply to those households. Key takeaways: - Tax-managed strategies may add material improvement to after-tax returns. While this may vary by tax rate and strategies used, it may add between 0.8% and 1.9% to after-tax returns. - While there is little change seen for household incomes below $400,000, taxes remain a drag on investment performance. = For investors with incomes between $400,000 and $1 million, the impact of the tax changes appears modest. = The impact is more substantial for investors with household incomes over $1 million, especially for those invested in actively managed strategies. Employing tax-managed strategies will become even more important for these investors. Direct indexing: manage tax costs Holding securities directly in a separately managed account makes investing less taxing. While index mutual funds and ETFs are relatively tax-efficient, the better way to lower investment taxes is with an SMA. In an SMA, the investor owns all the securities directly, so the portfolio manager can use tax loss harvesting and other techniques to reduce or eliminate taxable capital gains. Direct indexing strategies at Active Index Advisors® are focused on producing enhanced after-tax returns. These SMA portfolios can be customized for tax purposes, to align with investor values and concerns, or a combination of both. All accounts are actively managed to optimize tax loss harvesting while providing beta exposure to an index. This type of solution can help investors mitigate tax liability in their portfolios, minimize capital gains, and plan for future taxable events. Tax management techniques available through Unified Managed Accounts that incorporate a tax overlay may also be beneficial for high-income earners. Overway also points out that municipal bond SMA strategies generating tax-advantaged income will become more appealing on the margin. Overall, there are a number of techniques that can be employed through the investor lifecycle that may increase the after-tax return. We encourage close collaboration between financial advisors and tax professionals to help design the best course of action for each client.
Visit im.natixis.com for our range of SMA strategies that offer specialized solutions for high net worth and multiple manager portfolios, including a focus on trading efficiency and tax management.
This material is for informational and illustrative purposes only and does not represent an actual account. Performance data shown represents hypothetical past performance and is no guarantee of, and not necessarily indicative of, future results. There can be no assurance that developments will transpire as forecasted. It does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of a specific investor.
accelerating growth
gatekeepers rev engines
Custom kits in every color
Facts & figures
An ETF may be a tax-efficient option for the taxable investor—but a custom SMA can be even better. Learn what else this choice can provide.
Rey Santodomingo, CFA
Continuing a trend of the past five years, exchange-traded funds (ETFs) grew in assets under management (AUM) in 2020. More investors are using ETFs as they shift from active to passive investing. One favored advantage of ETFs is tax efficiency due to the low turnover associated with index-based investments, in addition to many ETF providers’ use of the creation and redemption process to reduce capital gains distributions. However, the fact remains that the ETF continues to be a one-size-fits-all solution that isn’t optimal for everyone. The flexibility of a custom passive separately managed account (SMA) can beat an ETF in terms of tax efficiency in many cases. Let’s look at a few examples. Advantage #1: Tax-loss harvesting A custom passive SMA is a superior vehicle for delivering the value of tax-loss harvesting. This value comes through realizing tax losses that can be used to offset capital gains. In a custom passive SMA holding many securities, loss-harvesting opportunities are more plentiful because each security is a potential loss-harvesting trade. Even when the market is up, investors can still find losses in a tax-managed portfolio. With ETFs, investors need to wait for the entire market to go down before they can harvest any losses. Advantage #2: Transition of appreciated securities or concentrated positions A custom passive SMA allows investors with existing stock portfolios to more effectively transition to an index-based exposure over time. A custom passive SMA manager can analyze an investor’s existing securities, decide which ones to keep, and carefully sell out of non-index names, using the proceeds to invest in securities that help reduce tracking error to the index. It’s important in transitions like this to take gains and losses into account, since the sale of each appreciated security can result in capital gains taxes. A custom passive SMA manager can use the losses embedded in the portfolio to offset any gains realized. On the other hand, an ETF investor has a much harder time making a careful transition, because they don’t have the ability to work with the granularity of the individual stocks. Often they’re stuck with liquidating the portfolio and buying the ETF, which can trigger a large tax bill. Advantage #3: Double benefit of charitable gifting A custom passive SMA provides a superior tax-advantaged way to give to charity. This type of portfolio enables clients to gift highly appreciated securities, which provides the benefit of the charitable gift deduction and also helps investors avoid the capital gains tax associated with the position. While an ETF portfolio can also become appreciated, a custom passive SMA will contain highly appreciated securities that have outpaced the market and cap-weighted index-based ETFs in recent years—making them a much more tax-advantageous security to gift. For example, three major tech stocks went up 64% on average in 2020, compared with 18.4% for the S&P 500®. The bottom line To solve for optimal after-tax results, investors need to take into account key inputs that are unique to their situations. These inputs can include their portfolio’s level of appreciation; tolerance for tracking error or speed of transition; and federal, state, and local tax rates. When these variables are taken into account, the benefit of a custom passive SMA and tax-efficient management is that the investor can get a more optimal after-tax return than they can from an ETF. Visit www.parametricportfolio.com
Managing Director, Investment Strategy
“The ETF continues to be a one-size-fits-all solution that isn't optimal for everyone”
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks. ©2021 Parametric Portfolio Associates® LLC. All rights reserved. 800 Fifth Avenue, Suite 2800, Seattle, WA 98104. NOT FDIC INSURED. OFFER NOT A BANK GUARANTEE. MAY LOSE VALUE. NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY. NOT A DEPOSIT.
WILL SCHMITT
Three gatekeepers tell us how they do due diligence on SMAs, what’s driving demand, and where things are going next
Are SMAs becoming more popular at your firm? They’re becoming more popular, and we are also seeing that more firms are launching them. Firms that weren’t doing this five years ago are now in the business, and that’s helping to increase the popularity. What’s driving this? I think this is a big client push, because clients are realizing they want to have more access to different vehicles. It’s also coming at the advisor level as well. There’s just an advantage from a fee standpoint, and a customization standpoint, to have multiple vehicles, and SMAs fit that role.
Are you seeing a decline in any other investment vehicle’s popularity as a result? We are seeing more popularity with the SMAs, and likely, the money is coming away from mutual funds, but I wouldn’t want it to be portrayed that mutual funds are going away or that they’re not popular. It’s just the customization, the potential for lower fees with an SMA, that makes it more desirable for clients who can meet those investment minimums. For which type of clients do SMAs make the most sense? Given that SMAs have higher minimums, the clients who usually fit that mold have more sizable assets. Also, ones who want more control over trade, taxes or customization. When it comes to things like values aligned or ESG, that can be more easily implemented in an SMA format. Which categories of SMAs are most popular? The reality is it’s a lot easier to do it within equities because it’s easier to replicate. Within fixed income, it’s a little bit harder, but there’s still demand there.
Are SMAs becoming more popular at your firm? SMAs represent about 10% of our firm’s assets under management, so most of our clients don’t use them. Most of our clients are either using funds or ETFs. There are some situations where we use SMAs, whether it’s for customization or tax issues for the client, where they would prefer the SMA vehicle over a fund. Does your due diligence differ when assessing SMAs? I think our research process is the same for both. Whether it’s a fund or separate account, we’re really trying to understand the manager, because that’s the most important part. Whether it’s a mutual fund or an SMA, we want to understand the process, the people, the track record. Where there is increased demand for SMAs, is that being driven by advisors or asset managers? It’s probably usually from the advisor, because they’re working with their client, trying to find the best vehicle, the best way to structure the client portfolio. How do you use SMAs? We run a dividend growth SMA internally. If a client has a number of those types of stocks already in their brokerage account, rather than selling all those stocks and investing them in a mutual fund, we’ll incorporate those and manage a more custom, tax-sensitive version of our separate account strategy.
Do you offer direct indexed strategies? We don’t do direct indexing at this time. It’s something we’ve looked into because, certainly from a tax perspective, something like that could be beneficial.
Are SMAs becoming more popular at your firm? I’d say it’s been pretty steady in the past couple of years. We’ve had about $10bn in SMA appreciation over the past five years and most of that is market appreciation. On average, I think we add about 10 to 15 SMAs per year. But on the flows side, I don’t see really huge growth numbers. Is interest in SMAs being driven by asset managers or advisors? Mostly advisors. They just like to make their own decisions, they pick up different SMAs, and then they make their own models. Do you offer direct indexed strategies? That’s a pretty hot topic, and our team has been spending time on this. On the ESG side, some people want a more customized index-based ESG choice. We do have offerings, but apparently they cannot cover all the demand from the field, so we have to do a little more work there to maybe expand the offerings. Does the due diligence process differ compared to mutual funds or ETFs? Overall, I would say the core of the due diligence process is pretty much the same. We try to pay attention to the firm, to the team, to their process, and of course, the portfolio construction. SMAs are available for lower fees but with less flexibility – as in we don’t have any flexibility with those fees, whereas in a mutual fund, a lot of times, we do have flexibility.
Are SMAs becoming more popular at your firm? They’re becoming more popular, and we are also seeing that more firms are launching them. Firms that weren’t doing this five years ago are now in the business, and that’s helping to increase the popularity. What’s driving this? I think this is a big client push, because clients are realizing they want to have more access to different vehicles. It’s also coming at the advisor level as well. There’s just an advantage from a fee standpoint, and a customization standpoint, to have multiple vehicles, and SMAs fit that role. Are you seeing a decline in any other investment vehicle’s popularity as a result? We are seeing more popularity with the SMAs, and likely, the money is coming away from mutual funds, but I wouldn’t want it to be portrayed that mutual funds are going away or that they’re not popular. It’s just the customization, the potential for lower fees with an SMA, that makes it more desirable for clients who can meet those investment minimums. For which type of clients do SMAs make the most sense? Given that SMAs have higher minimums, the clients who usually fit that mold have more sizable assets. Also, ones who want more control over trade, taxes or customization. When it comes to things like values aligned or ESG, that can be more easily implemented in an SMA format. Which categories of SMAs are most popular? The reality is it’s a lot easier to do it within equities because it’s easier to replicate. Within fixed income, it’s a little bit harder, but there’s still demand there.
Are SMAs becoming more popular at your firm? SMAs represent about 10% of our firm’s assets under management, so most of our clients don’t use them. Most of our clients are either using funds or ETFs. There are some situations where we use SMAs, whether it’s for customization or tax issues for the client, where they would prefer the SMA vehicle over a fund. Does your due diligence differ when assessing SMAs? I think our research process is the same for both. Whether it’s a fund or separate account, we’re really trying to understand the manager, because that’s the most important part. Whether it’s a mutual fund or an SMA, we want to understand the process, the people, the track record. Where there is increased demand for SMAs, is that being driven by advisors or asset managers? It’s probably usually from the advisor, because they’re working with their client, trying to find the best vehicle, the best way to structure the client portfolio. How do you use SMAs? We run a dividend growth SMA internally. If a client has a number of those types of stocks already in their brokerage account, rather than selling all those stocks and investing them in a mutual fund, we’ll incorporate those and manage a more custom, tax-sensitive version of our separate account strategy. Do you offer direct indexed strategies? We don’t do direct indexing at this time. It’s something we’ve looked into because, certainly from a tax perspective, something like that could be beneficial.
Henry Orvin Senior Vice President Mondrian Investment Partners
A brief look at the preferred and capital securities market, the changes wrought by the pandemic and how we plan to move forward.
Mark A. Lieb
James Hodapp
We recently spoke with Mark Lieb, Founder and CEO and Jim Hodapp, SVP and Portfolio Specialist at Spectrum Asset Management to discuss these important topics and why now might be a good time to consider allocating a portion of your portfolio to this quality, defensive, tax-advantaged asset class. 1. What are preferred and capital securities and why might investors consider them at this time? Preferred securities are a segment of corporate fixed-income securities that are subordinated below senior debt and hold a preferred rank above common stock. The very first being preferred stock. The market has significantly grown and evolved over the years. In addition to traditional preferred stock, the preferred securities universe now includes subordinated debt, junior subordinated debt as well as contingent capital securities (CoCos). The primary issuers are regulated banks, insurance companies, and utilities as well as some telcoms, industrials, REITs, and other corporates. Like bonds and other fixed income securities issued at a par value, holders receive a coupon payment but do not share in the upside net worth growth of the company as do common stock equity holders. There are several similarities and differences between types of securities within the preferred and capital securities universe. For example, both are issued at par value and are subject to a call feature (typically 5- or 10-years from the date of issuance). The call terms can vary; they may be fixed-for-life, fixed-to-float, fixed-to-reset, or floating. Both subordinated and junior subordinated capital securities, which are primarily issued by insurance companies and utilities, are dated with a specified date of maturity and cumulative. The traditional preferreds and CoCos, which are primarily issued by U.S. and non-U.S. banks pursuant to regulatory AT1 Capital rules, are perpetual and non-cumulative. That is, often issuers may defer coupon payments (cumulative) or temporarily eliminate coupon payments (non-cumulative) without accelerating default; provided the issuer has also suspended common stock dividend payment. The preferred and capital securities universe can be referred to as the “Preferred, Hybrid, Subordinated or Capital Securities” market – which all describe the collective market universe. A key takeaway is that these securities are typically issued by well capitalized corporate issuers whose senior debt (enterprise level) is Investment Grade (IG) rated (typically rated A- to BBB+). By going down the capital structure to subordinated securities (typically rated BBB/BB), investors receive a higher yield. The “High Yield” market is different. High yield bonds are below investment grade senior debt at the enterprise level. Our market is the yield pick-up for subordination, the universe of high yield bonds issuers is very different. We believe the market for preferreds and junior subordinated capital securities is strong as the fiscal spending/vaccination/re-opening dynamic continues to foster higher equity valuations and tighter spreads. We expect that demand for subordination premium will continue to be robust given the significant amounts of capital that are looking for returns in a yield starved world. 2. How does Spectrum Asset Management approach investing in this market and could you provide insight into your investment philosophy and process? Spectrum’s investment philosophy is focused on capital preservation, while seeking enhanced yield and moderate capital appreciation resulting from an actively managed portfolio of subordinated securities. From our founding in 1987, Spectrum’s investment process has two distinct drivers: 1) credit quality analysis by the research team and 2) security selection and portfolio construction by portfolio management. The credit research process combines top-down and bottom-up analysis. Top-down is focused on typical global and regional macro-economic and political factors. Bottom-up is focused on specific credit quality fundamentals. In terms of fundamentals, our team employs CAMEL Analysis – looking closely at each issuer in terms of Capital, Asset Quality, Management, Earnings and Liquidity plus ESG. The process is dynamic and ongoing and the team is actively in touch with industry analysts and issuer management. The team continuously updates and maintains internal scores and relative ranking for each of the CAMEL components based on the fundamental attributes. The credit team sets maximum exposure limits for each specific issuer that has been approved based on credit quality. The portfolio management process combines security selection based relative-value analytics along with tactical portfolio construction based upon risk/reward factors which incorporate issuer, security type, industry, and regional diversification as well as establishing portfolio credit, yield and duration targets. While the essence of our investment process has remained steadfast, we continue to adapt and evolve along with the changes in our market. Most importantly, the portfolio management process is supported by state-of-the-art tools to review, monitor, and evaluate relative-values, portfolio characteristics, guidelines, risk, liquidity as well as providing efficient trade processing, attribution analytics, compliance controls. 3. What misconceptions might investors have about preferred and capital securities? The greatest misconception is that the different type of securities and call features can seem complex and confusing at first. Our market falls squarely within the corporate fixed income category – but spans across the traditional demarcation between investment grade (BIG) (e.g., BBB) and the upper-end below-investment-grade (e.g., BB). We have been focused on this market for 40 years and always aim to demystify initial misconceptions that these securities may be too complex or confusing to understand. The fact that we span the IG/BIG credit gap and have a wide-range of security structures is an advantage; providing greater opportunities to derive added-value for our clients. 4. How was this market impacted by Covid-19 – and what portfolio changes did you make? The COVID-19 pandemic has reshaped the world. We firmly believed that financials entered the crisis from a position of strength, despite major uncertainty and headwinds. During the outbreak of the COVID-19 pandemic – the flight to quality impacted both equity and credit markets alike. Credit spreads significantly widened. In short order, investors recognized that bank and insurance company balance sheets were strong, largely due to the regulatory reforms adopted after the Financial Crisis, and accordingly, our market quickly stabilized and recovered. COVID-19 once again showed that our focus on credit research and security selection is very important. 5. What is Spectrum’s outlook for this market over the next few years? Our focus is on the post-COVID-19 recovery and Central Bank policy which will play-out over the next few years. Against the backdrop of an actively intervening U.S. Federal Reserve (Fed) and loose European Central Bank (ECB) monetary conditions, we hold a constructive 2021 outlook for global junior-subordinated capital securities. We are moving toward normalization of the yield curve, which is a positive for the banks and insurance companies alike. Given the range of security structures available in our market – we can be adaptive to market conditions. We can shift duration downward and we are focused on call terms that provide greater yield protection. Investors are searching for yield and we are well positioned. Bottom-line, we believe that our markets have been and will remain attractive. 6. What are the different types of preferred SMAs that are available from Spectrum? Spectrum offers a broad range of products to serve the needs of our clients. In addition to several mutual funds that we manage for U.S. investors and non-U.S. investors, we offer four SMA Models offered via platform wrap-program sponsors. We can also provide customized SMA portfolios for institutional investors. All are managed by the same team and similarly draw upon the firms’ investment process. To learn more about how preferred and capital securities can potentially benefit your portfolio; contact your Principal Global Investors representative.
Founder, President and Chief Executive OfficerSpectrum Asset Management
Senior Vice President and Portfolio Specialist Spectrum Asset Management
This material is provided by and reflects the current views and opinions of Spectrum Asset Management, Inc., an affiliate of Principal Global Investors. Principal Global Investors leads global asset management at Principal®. Spectrum is a leading manager of institutional and retail preferred securities portfolios. Investing involves risk, including possible loss of principal. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Risks of preferred securities differ from risks inherent in other investments. In particular, in a bankruptcy, preferred securities are senior to common stock but subordinate to other corporate debt. This material may contain ‘forward-looking’ information that is not purely historical in nature and may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction © 2021 Principal Financial Services, Inc. Principal, Principal and symbol design, and Principal Financial Group are trademarks and service marks of Principal Financial Services, Inc., a member of the Principal Financial Group. MM12213 | 06/2021 | 1666455-062022
