The evolution of investing over the past 70 years or so looks something like this:
In the 1950s, the majority of individual investors purchased individual securities. In fact, retail investors executed 90% of all trades on the New York Stock Exchange. Today that number is more like 5%, with the remaining 95% being executed by professional investors.
In the 1960s, the star mutual fund manager was born and investors diversified their holdings.
In the 1970s, the index fund brought low-cost investing in market beta to the masses.1
In the 1990s, ETFs were introduced as a more tax-efficient way to invest in a variety of rules-based strategies.
In the 2010s, robo-advisors brought more operational efficiency and technology into the process of asset allocation and goals-based investing.
In the 2020s, customization will be the next step in investing technology.
The three biggest trends in this customization boom will be:
(1) Direct indexing
(2) ESG investing
(3) Defined outcome investing
Direct indexing has been around for a while now but the move to zero commission trades and the improvements in operational efficiency brought about by technology will supercharge this trend in the years ahead.
The difference between direct indexing and simply owning a low-cost index mutual fund or ETF is the ability to customize your indexes to adhere to certain rules, exclusions or tax situations.
Patrick O’Shaughnessy recently wrote about his firm’s Canvas platform and I’m in agreement with his assessment:
By 2025, most financial advisors will use web-based software to create and manage Custom Indexes for their clients. Standard indexes have a single methodology; one ruleset dictating what they own and how they rebalance. Standard indexes are “one size fits all.” Like standard indexes, Custom Indexes also invest and rebalance according to a defined methodology. But with Custom Indexes, the methodology is personalized based on an investor’s circumstances and preferences and can be easily adjusted as an investor’s circumstances change. This flexibility is possible because Custom Indexes are implemented through separate accounts, where investors can directly own a custom mix of individual stocks and bonds rather than indirectly owning positions through a collection of funds and ETFs.
Custom Indexing is a technology, and technology often removes barriers. Co-mingled funds and ETFs sit in between investors and the stocks they own. Funds and ETFs have been good to investors and were wonderful technologies in their own rights. But Custom Indexing software, zero commission trading, and fractional share trading mean that in the future, more investors will own their shares directly rather than through mutual funds and ETFs.
For the sake of full disclosure, my firm was an early adopter of Canvas so there might be some confirmation bias at play here. But working with Canvas from the early days has shown me what this type of platform can do for clients.
We’ve likely only scratched the surface in terms of the customization of investment strategies but the tax features are by far the most impressive from a financial planning perspective.
Managing single company risk, setting tax budgets while transitioning legacy holdings and offsetting gains through tax-loss harvesting can all be done more efficiently through the use of software.
ESG investing has also existed for some time but the ability to do so in a way where you can set your own guidelines is going to decrease the barriers to entry in this space.
Young people will care more about values-based investing than older generations for the simple fact that it wasn’t really an option in the past to invest this way.
Millennials already outnumber baby boomers in this country and will be entering their prime savings years in the 2020s. Bank of America estimates Gen Z will see their incomes grow fivefold over the next 10 years.
A handful of surveys of high net worth millennials have found anywhere from 87% to 95% would like to tailor their investments to their values. As a member of the anti-survey coalition, I don’t necessarily take these numbers at face value.
But the ease with which young people will be able to tailor their investments to their principles will accelerate this trend, even if adoption rates aren’t that high.
Many ESG funds of the past made it difficult to establish specific criteria for inclusion or exclusion from a portfolio. Direct indexing solves this problem, allowing investors to determine the industries, companies or attributes they’re looking for on a more granular level.
Plenty of people in the investment profession don’t understand the need for making portfolio decisions based on environmental, social or governance characteristics but values-based investing can have an impact if it helps clients stay invested in a portfolio they care about.
Defined outcome investing dates back to the derivatives boom that more or less took off in the 1980s. This is another area that will benefit from lower fees, improved technology and better access for retail investors.
We’ve spoken with Bruce Bond of Innovator ETFs and Jason Barsema of Halo Investing in recent months on our podcast about this space.
Structured notes and defined outcome ETFs allow investors to set parameters around their risk assets in terms of defining the protection against loss, the underlying asset and potential payoffs.
These products are not a savior to a portfolio and come with their own unique set of risks but in a world with low interest rates, many advisors will find it difficult to ignore these types of products if they don’t have other solutions.
The ability to go into a technology platform or fund provider and say you want 30% downside protection over a 3 year period (I’m making up numbers here) and have it spit out what sort of return you could earn based on certain holdings will be appealing to many advisors and clients alike.
Customization itself presents a number of new challenges for advisors and their clients.
Education will be key, not only for clients but for the advisors themselves in terms of how these products and platforms work. Many will decide this level of customization is unnecessary but they have to educate themselves on it first because clients will be asking about it as this stuff becomes more prevalent.
Implementing new technologies also requires the right people operationally to integrate with current systems, ensure the reporting makes sense, explain it to people in a way they can understand it and teach both employees and clients how to use it correctly.
I’m still not sold on this level of customization taking off in a big way in the DIY retail investor world.
But for RIAs, new technologies and customization can help further enhance the relationships and offer new solutions for clients.
Talk Your Book: Direct Indexing
1Although it is worth pointing out index fund adoption took a few decades.