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®
The Post-Fund Paradigm Shift
Dynamic Custom Indices:
Drivers, Constraints, and
Tipping Points
The Post-Fund Paradigm Shift
Dynamic Custom Indices: Drivers,
Constraints, and Tipping Points
Transaction Costs and Price Pressure Push Funds toward Passive Investing
Increasing Demand for Personalization
Increasing Demand for ESG Investments and Corporate Data
Investment Management is Ripe for Disruption
Back to the Future: Trading Individual Securities
Ripple Effects: DCIs and Smart Tax Management
The Limitations of DCIs
Approaching the Tipping Point
Market Forces Pushing Asset Managers Downstream
Increased Competition between Asset Managers and Financial Advisers
The Future Starts Now
I. Industry trends challenging the fund-based paradigm
Executive Summary 3
14
15
15
16
18
20
20
21
5
4
6
9
12
II. The Post-Fund Paradigm
3
Industry trends
challenging the fund-
based paradigm
Executive Summary
Dynamic custom indices (DCIs) are on the rise, with large implications for the
investment management industry. These diversified investment portfolios,
comprised of individual securities and managed by software, dynamically
rebalance portfolio allocations to reflect client-specific factors.
The rise of DCIs coincides with several demand-side trends, including:
Tumbling fees and costs, competitive trends, and the increasing availability
of both DCI technology and ESG (environmental, social and corporate
governance) data are expected to lead to structural changes in the investment
industry. Given these changes, DCIs are well-suited to become the norm in
public equities investing, leading to new opportunities and imperatives for the
wealth management industry.
Customer pressure on investment managers to decrease advisory
and management fees.
Massive fund flows from active to passive strategies.
A need for investment managers and intermediaries to differentiate,
especially in the wake of recent growth in passive ETF strategies
and consumer-facing technology solutions.
Growing consumer interest in personalized investment products,
particularly from clients who have a strong interest in aligning their
investments with their values
I.
Industry Trends Challenging the
Fund-based Paradigm
®
5
Industry trends
challenging the fund-
based paradigm
Transaction Costs and Price
Pressure Push Funds toward Passive
Investing
Consumer transaction costs have decreased over time, and this trend is
expected to continue.
When mutual funds and ETFs were first created, they offered individual
investors significant savings on transaction costs, as consumers were able to
create diversified portfolios without the tremendous cost and complexity of
buying each security individually. This decrease in cost played a significant role
in their mass adoption by individual consumers.
In recent years, fund fees have declined significantly, in part accelerated by
the tremendous fund flows from active to passively managed funds. Overhead
and management fees have fallen as technology automates work previously
done by analysts, traders, and portfolio managers. While John Bogle was widely
criticized1 when Vanguard’s first index fund collected only $11 million at first
underwriting in 1976, the assets in passive equity funds now match those in
active equity funds. Additionally, clients have increasingly accepted the use of
algorithms for asset allocation, driving down the cost of fund management.
As the asset management industry noticed the acceleration of assets flowing
into passively managed products, more and more passive funds were launched,
turning index funds into a commodity. This has applied tremendous price
pressure on investment products, especially on traditional, actively managed
mutual funds. In 2018, Fidelity introduced zero-fee funds, cementing a
fundamental change in the business model of investing: revenue is no longer
based on assets under management.
1 https://www.businessinsider.com/vanguard-jack-bogle-first-index-fund-criticism-2019-1
6
Increasing Demand for
Personalization
The competitive landscape for financial advisers is much broader and more
varied than ever before. Robo-advisers promise market performance for
fees that are often half of what an independent adviser charges. Digital-first
investment advisers are capturing the attention and assets of investors earlier
in their financial lives. Clients are increasingly aware of the option to bypass
their adviser and buy funds directly. The communications revolution has also
widened advisers’ traditionally local markets, since advisers can now provide
services to practically any geographic location. These elements combine to
pressure advisers to justify their fee structure against more economical options,
and the emergence of fee-only practices3 is no coincidence.
0
2000 2005 2010 2015
0.25
0.50
0.75
1.00
1.25%
Exhibit 1
Asset-Weighted Average Fees for Funds Decline 8% in 2017
Graph sourced from
Morningstar.com2
Active All Funds Passive
2 https://www.morningstar.com/blog/2018/05/11/fund-fee-study.html3 https://www.wealthmanagement.com/industry/advisors-use-fixed-planning-fees-rise
7
Industry trends
challenging the fund-
based paradigm
Additionally, wealth managers and wealth management platforms are
threatened by their own vendors. As fund managers consolidate, with low-fee
ETF offerings, advisers are no longer receiving incentive payments such as
12(b)-1 fees for selling the fund managers’ investment products. Yet, they are
forced to carry these products because clients have learned to ask for low-fee
solutions. Applying even more pressure, many wealth managers are at risk of
their clients bypassing them to buy the ETFs directly.
These changes are forcing investment advisers to compete more aggressively
for new business. While many still lean heavily on client and professional
referrals to build their book of business, they must now earn the privilege of
working with clients who are more aware of their alternatives. Some advisers
have responded by serving a more specific clientele, adopting more technology
solutions, or merging with other firms to manage fixed costs. Changes in the
financial advice market reflect these pressures, with unprecedented levels of
consolidation in recent years and a dramatic growth in industry spending on
technology4.
The proliferation of low-cost, mass-produced investment approaches coincides
with an increased appetite for customization across many consumer segments.
An estimated 36% of consumers5-- and 55% of US Millennials6 -- are interested
in buying personalized products and experiences, with many willing to pay a
premium. These requests include a desire for help with private placements,
taxes, philanthropy, stock options, and the management and refinancing of
educational and real estate debt.
4 https://www.wealthmanagement.com/industry/banner-year-deals-thanks-ria-consolidators5 https://www2.deloitte.com/content/dam/Deloitte/ch/Documents/consumer-business/ch-en-
consumer-business-made-to-order-consumer-review.pdf
6 https://www.uspsdelivers.com/why-personalization-may-help-you-win-with-millennials/
PRICE ISN’TTHE BARRIER
WILLING TO PAYA 20% PREMIUM
consumers who expressedinterest in personalized products or services are
1 in 5
8
Industry trends
challenging the fund-
based paradigm
Separately Managed Accounts (SMAs) have grown significantly since the
financial crisis7, in part due to the flexibility they offer in terms of tax-efficiency,
customization, transparency, and professional management. Firms from Morgan
Stanley to Goldman Sachs tout their ability to personalize portfolios, though
they generally reserve these services for their wealthy clientele because, when
stock selection, portfolio management, and client interactions are all conducted
by people, SMAs are only economically viable for clients with several million in
investable assets.
All told, the investment management industry is moving from a one-size-fits-all
approach to an age of personalization8.
7 https://www.investmentnews.com/article/20140815/BLOG09/140819939/why-separately-
managed-accounts-are-undergoing-a-rebirth
8 https://www.wealthmanagement.com/client-relations/personalization-key-winning-emerging-
investor-loyalty
Source: Deloitte9
9
Industry trends
challenging the fund-
based paradigm
Increasing Demand for ESG Investments
and Corporate Data
In the coming years, investors will increasingly move their assets to impact
issues they care about. Industry bodies currently estimate that ESG-linked
assets comprise $12 trillion in the US and $30 trillion globally, with one report
showing the segment growing at 17% per year.10
9 https://www2.deloitte.com/content/dam/Deloitte/ch/Documents/consumer-business/ch-en-
consumer-business-made-to-order-consumer-review.pdf10 https://www.institutionalinvestor.com/article/b15cc1dxds8k97/mckinsey-esg-no-longer-niche-as-
assets-soar-globally
10
This rapid growth has also increased the demand for ESG data from asset
managers. Historically, company sustainability disclosure has been lackluster,
sporadic, and PR-focused, not impact-oriented. However, as shareholders have
joined forces to demand better disclosure on ESG issues, issuers have begun
to respond:
Eighty-five percent of S&P 500 companies published sustainability or
corporate responsibility reports in 2017, compared to less than 20% of
companies reporting ESG data in 2011.12
Companies reporting environmental impact data to the nonprofit CDP now
comprise over half of global market capitalization. Over 7,000 companies
reported last year, up 11% from the year before.13
$0
1995 1997 1999 2001 2003 2005 2007 2010 2012 2014 2016 2018
$2,000
$4,000
$6,000
$8,000
$10.000
$12,000
$14,000
Figure A
Sustainable and Responsible Investing in the United States 1995-2018
ESG Incorporation Overlapping Strategies Shareholder Advocacy Graph sourced from
ussif.org11
11 https://www.ussif.org/sribasics12 https://www.ga-institute.com/press-releases/article/flash-report-85-of-sp-500-indexR-
companies-publish-sustainability-reports-in-2017.html13 https://www.cdp.net/en/scores
To
tal A
sse
ts in
Bill
ion
s
11
Industry trends
challenging the fund-
based paradigm
$0
2003 2004 2005 20072006 2008 2009 2010 2011 2012 2013 2014 2015
1000
2000
3000
4000
5000
6000
7000
8000
2016 2017 2018
Total disclosing companies
Companies disclosing on climate change
Companies disclosing on water security
Companies disclosing on forests
Graph sourced from
CDP.net15
14 https://sustainableinvesting4all.com/great-web-sites/sustainable-investing-research-and-ratings/15 https://www.morningstar.com/blog/2018/05/11/fund-fee-study.html
As the availability of ESG data increases, the costs for investors to source this
data is expected to decline. The proliferation of ESG data providers is likely to
accelerate this trend, lowering the barrier for investors to make use of ESG data
in their investment decisions.14
# o
f co
mp
an
ies
12
Industry trends
challenging the fund-
based paradigm
These concurrent trends combine to create a status quo unlikely to persist. To
recapitulate:
The incumbent product set is expensive. According to a 2016
Morningstar study, actively managed equity funds charge an average
expense ratio of 1.45%, compared to 0.73% for index mutual funds and
0.23% for ETFs.
Mutual funds are pre-packaged by design, and represent a static ethical
investing framework unsatisfactory to ESG-focused clients. Currently,
if a clients’ views diverge from the asset manager’s, they do not have the
ability to influence the asset manager’s approach or the fund’s holdings.
Additionally, while fund managers can customize a fund’s holdings to a
client’s requests if the client’s assets are held in an SMA, most institutional
asset managers only make SMAs available for multi-million dollar
accounts, meaning investors can only expect a customized portfolio if
their assets rise above a relatively high level.
The “Great Wealth Transfer” is underway. In this transfer, more than $30
trillion is expected to pass from the richest generation, Baby Boomers,
to their children and grandchildren, Millennials and Generation Z16.
These later generations are bigger17, more diverse18, and more socially
conscious19 than the ones that came before, and they expect products and
services from companies with a conscience.
Investment Management is Ripe
for Disruption
16 https://www.investopedia.com/advisor-network/articles/great-wealth-transfer/17 https://money.cnn.com/interactive/economy/diversity-millennials-boomers/ 18 https://www.npr.org/2018/11/15/668106376/generation-z-is-the-most-racially-and-ethnically-
diverse-yet19 https://www.forbes.com/sites/sarahlandrum/2017/03/17/millennials-driving-brands-to-practice-
socially-responsible-marketing/#44e3a3d4990b
-600
2000 2001 2002 20042003 2005 2006 2007 2008 2009 2010 2011 2012
-400
-200
0
200
400
600
800
$1,000
2013 2014 2015 2016 2017
13
Industry trends
challenging the fund-
based paradigm
Two-thirds of Millennials and Gen Z20 expect companies to personalize
their offers. The growth in consumer-facing technology has changed
expectations of the costs and ubiquity of customized solutions.
Account personalization is easier and more modular than ever before.
This change is largely spurred by the growing availability of ESG data and
the dramatic drop in transaction costs, especially trading costs.
The movement towards quantitative passive strategies has been a catalyst for
the industry to shift towards fully automated security allocation and trading.
Similarly, as ETF prices near zero, the industry will be forced to consider new
business models less dependent on volume.
21 https://www.morningstar.com/blog/2018/05/11/fund-fee-study.html
Exhibit 4
The Shift into Low Fee-Ranked Funds Accelerates
Graph sourced from
Morningstar.com21
Cheapest 20% Remaining 80%
US
$ B
illio
ns
II.
The Post-Fund Paradigm
15
The Post-Fund Paradigm
Back to the Future: Trading
Individual Securities
Ripple Effects: DCIs and Smart
Tax Management
As these trends grow, they continue to erode the benefits of mutual funds
and ETFs. Technology is making it increasingly possible for investors to buy
individual securities aligned with personal values and tax optimization at
acceptable costs. Investors and advisers may create their own index funds, an
approach that would disintermediate existing fund managers.
From these macro-trends, which industry expert Michael Kitces hypothesizes
will all overlap, ESG could break out of a specialized investment product to
become a mainstream feature.22
Tax loss harvesting (the practice of selling securities that have sustained losses
to reduce a portfolio’s tax liability) presents a significant opportunity for DCIs
22 https://www.kitces.com/blog/indexing-2-0-how-declining-transaction-costs-and-robo-indexing-
could-disintermediate-index-mutual-funds-and-etfs/
16
The Post-Fund Paradigm
The value of tax loss harvesting ranges from 0.15% to more than 0.70% annually
over a customer’s lifetime23. Since approximately one quarter of U.S. corporate
stock is held in taxable accounts24, many investment advisers offer tax-loss
harvesting. However, this exacting trading work is often done manually and
annually, with its effectiveness limited in investment vehicles like mutual funds
and ETFs.
The algorithmic trading technology underlying DCIs is uniquely suited to this
kind of repeated, systematic task. As DCIs hold individual securities, they
allow much greater granularity (and therefore greater impact) of tactics like tax
loss harvesting, while minimizing the risk of human error in execution. Both of
these features can provide benefits to clients leveraging DCIs to perform more
precise tax loss harvesting, a valuable feature of this new investment vehicle.
The Limitations of DCIs
As outlined, DCIs present a number of opportunities and solutions to current
challenges faced by financial advisors when investing their clients’ assets. DCI’s
benefits do, however, come with their own drawbacks:
DCIs can be expensive. As a relatively new technology, the offering has
not been commoditized, and can therefore be priced at a premium. This
is not an inherent feature of the technology, however, and is likely to
decrease over time.
23 https://www.nerdwallet.com/blog/investing/just-how-valuable-is-daily-tax-loss-harvesting/24 https://www.taxpolicycenter.org/taxvox/only-about-one-quarter-corporate-stock-owned-taxable-
shareholders
17
The Post-Fund Paradigm
DCIs do not perfectly track their underlying reference. This problem
is not unique to DCIs; all index-tracking investment products face this
challenge, with tracking error providing a tool to monitor any significant
deviance from the reference. Like most index-tracking products, however,
most DCIs will track their reference indices well enough to meet an
investor’s goals.
Many providers of direct indexing require high minimums. Wealthfront,
for instance, sets a $100,000 threshold for clients invested in their
direct indexing solution. Note, however, that direct indexing does not
necessitate a high account minimum, especially with the advent of
fractional shares, so this drawback of DCIs is likely to diminish over time.
Specialized software can be expensive. An adviser cannot reasonably
track the Russell 3000, for example, by hand, as she would need to
regularly perform thousands of trades
Additionally, while adoption of DCIs is expected to accelerate, the financial
services industry does exhibit structural barriers expected to slow DCI adoption:
The investment industry is inherently sluggish. The industry is highly
regulated, and its members are typically cautious or reluctant in their
adoption of new technology.
Investment advisory firms rely on legacy technology. This technology
is typically held over from an earlier wave of terminal-based and non-
cloud mainframe computing, and these firms will not replace their
legacy systems without extensive and time-consuming risk management
analyses.
The existing client base exhibits a lot of inertia. This observation is
supported by high retention rates, and may be due to the customer
base being price- and quality-insensitive. After all, if a client is personally
interested in investing and finance, they might forego an adviser’s
services entirely.
18
The Post-Fund Paradigm
Approaching the Tipping Point
We expect the transition to DCIs to follow Everett Rogers’ Diffusion of
Innovations model, which describes how current and potential adopters
interact:
The Early Adopters will adopt DCIs once a rational economic threshold
is reached and the costs to use this new technology are comparable to
existing equivalent options. (That rational calculation, however, will also
include a calculation of the enterprise value they can achieve from gaining
long term market share by acting as an early adopter and sustaining
higher margins for longer periods.)
The larger, slower majority will be motivated to make the shift after
large industry players see the competitive threat and race to catch up.
19
0
Categories of Adopters
Market Share %
Innovators2,5%
Early Adopters 13,5%
Early Majority34%
Late Majority34%
Laggards16%
25
50
75
100
Diffusion of Innovations
by Everett Rogers
Graph sourced from
Total Product
Marketing25
Market Share Technology Adoption Bell Curve
A number of tipping points could accelerate the industry’s movement toward
this high rate of DCI adoption.
25 https://totalproductmarketing.com/risk-of-adopting-cloud-computing-overcome/diffusion-
innovation-bell-curve/
20
The Post-Fund Paradigm
Market Forces Pushing Asset Managers Downstream
Increased Competition between Asset Managers and
Financial Advisers
As margins erode in investment products, asset managers will move
downstream to the next tier of prospective clients. They recognize that when
technology transforms an industry vertical, the only margins that ultimately
remain are where the human relationship remains, between an adviser and
their client.
These asset managers are responding to dissolving trading fees and other
revenue streams, resulting from the inverted yield curve and increased
regulations.
Earlier this year, Blackrock purchased Aladdin Wealth, adding it to their
FutureAdvisor robo solution. Goldman Sachs also purchased United Capital,
a platform with 22,000 registered investment advisers. These acquisitions put
asset managers in direct competition with financial advisers in capturing the
mass affluent client.
In response, wealth management platforms are increasing their offerings
of private-label asset management solutions. In short, they are seeking to
become investment product manufacturers. A distributor moving upstream
into manufacturing will surely seek to leverage its core competency: client
knowledge. Advisers know about clients’ life events, family situations, and
personal values. By implementing a software-based approach to manufacturing
(i.e. custom direct indexing) advisers can manufacture solutions on the spot
that are objectively superior for the client, sustain higher margins, and are well-
defended against the offerings of companies like Vanguard.
21
The Post-Fund ParadigmThe Future Starts Now
DCIs are the next evolution of financial technology. Their growing adoption by
industry players might foretell the future of the investment industry, which is
furiously re-tooling and rebranding to meet demand for customized products,
values-based investing, and smart tax management, particularly from Millennials
and Gen Z. In parallel, the commoditization and tumbling costs of ESG data and
trading services seem likely to remove the remaining barriers to widespread
DCI adoption.
As science fiction author William Gibson said, “The future is already here,
it’s just not evenly distributed.” DCIs are the future, on their way to be widely
distributed.
22
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