It’s no secret that direct indexing has taken off in the U.S. – an avalanche of high-profile acquisitions, fintech startups, and major platform launches have occurred over the last few years and momentum does not appear to be slowing. While direct index portfolios have been available for over 20 years, continued advancement of technology and structural industry changes have eliminated barriers to adoption, reduced cost, and created an environment conducive for the broader adoption of these types of strategies.
The value proposition that makes direct indexing an attractive solution in the U.S. also applies to Canada: advisors can provide a differentiated offering to their clients, wealth firms can mitigate fee pressures, and investors have greater control over portfolio construction through customization and tax management. It’s inevitable that direct indexing will find its way into the Canadian wealth market, but there are unique considerations for wealth and asset management firms and technology providers as they seek to offer direct index programs in Canada. Canadian wealth managers and advisors at the forefront of this trend stand to position themselves as market leaders, and experience better growth by meeting the demands for greater customization in retail portfolios.
Two Markets, Two Currencies
Broadly speaking, direct indexing is used to implement equity portfolios that can easily trade in liquid markets. For U.S. investors, a typical implementation would utilize the S&P 500 Index for the investor’s U.S. equity market exposure. Canadian retail investors typically have their equity exposure split between the Canadian and U.S. stock markets. Implementing a direct index portfolio across both of these indices is more complicated. Supporting this broader diversified equity exposure in a direct index portfolio requires more names/positions to deliver an equivalent level of tracking error, risk data for both security universes, and the ability to trade and hold securities on both exchanges and in both currencies. These are capabilities that the major Canadian platforms have long supported, but direct index portfolios can push the boundaries on the size and trade volume as compared to traditional managed accounts.
Managed Accounts Infrastructure
Direct index portfolios are implemented as separately managed accounts (SMA), in which the individual investor holds all of the underlying individual securities directly rather than through pooled investments such as mutual funds or ETFs. SMAs are more widely used in the U.S., which has driven competition across platforms and providers, reducing equity trading costs, increasing the availability of fractional share ownership and trading, and reducing the general operating costs associated with offering SMAs to smaller accounts efficiently. Major providers in the Canadian marketplace are catching up fast, though, particularly in the retail channel. The infrastructure to support direct index type separate account programs at scale is increasingly available in the Canadian market.
The Role of the Financial Advisor
Financial advisors play a key role in understanding the use cases for direct indexing, communicating the value of the solution to clients, and working with the client to customize the portfolio to best meet a client’s objective and investment policy requirements. The global wealth management industry has been moving increasingly towards passive investing for the last 20 years as demonstrated by the increased use of index-based ETFs and decreased use of actively managed mutual funds. In 2021, the market share of passive funds in the U.S. increased from 40% to 42%. In Canada, the market share for passive funds increased from 13.5% to 14.5%. Direct indexing is inherently a passive investment solution, and financial advisors who have already embraced passive investing are more inclined to understand and leverage direct index portfolios with their clients. Parametric and other providers in the U.S. have been building awareness of direct indexing and addressing specific complex client use cases for advisors across the industry for over 20 years. In Canada there are no large-scale direct index SMA providers. While these structural differences indicate a steeper learning curve for Canadian financial advisors, this represents an opportunity to invest in and lead education and training within the advisor community to help spur greater understanding and adoption more broadly.
Optimizing for Tax Management and ESG
Tax optimization is one of the primary value propositions of direct indexing, and while it offers some benefit to Canadian investors, structural differences in the tax codes reduce the value potential for Canadian investors. There are two primary differences in how taxes impact portfolio management between the U.S. and Canadian markets – (1) tax lots vs. average cost basis, and (2) differentiated short-term/long-term capital gains rates vs. a single capital gains rate.
U.S. portfolios hold individual tax lots that have their own cost basis established at the time of the original purchase. A tax optimization process can sell specific tax lots, providing greater control of specific gains realization, and allowing for intelligent decisions to avoid costs associated with Canadian portfolios, which only hold a single tax lot for each position, and average the cost basis within that position as additional purchases are made. The result is that a direct index portfolio for a Canadian investor has less opportunity to improve after tax return as compared to a direct index portfolio for a U.S. investor.
A particularly significant difference in tax treatment for U.S. investors is in the differentiated short- and long-term gain realization rates. The wider the difference in short/long term gains tax rates for an individual investor, the greater the value a tax optimization process can deliver by avoiding short-term gains realization (by holding a position greater than one year before selling, if that decision doesn’t introduce too much risk). A portfolio management process that accurately models the short/long term tax rates and associated risk of holding a position with a substantive gain beyond the one year long-term gains rate threshold can deliver significant incremental after-tax return for the U.S. investor. For Canadian investors, there is no such differential in rates and therefore no such opportunity for short-term gains deferral to improve after-tax return. So while there is value in tax loss harvesting for investors in Canadian portfolios, the tax optimization value opportunity is greater for U.S. investors.
The Opportunity for the Canadian Wealth Market
There is little doubt that direct indexing is coming to Canada, despite some of the current structural differences and obstacles relative to the U.S. market. Wealth management firms and technology and service providers that are able to address these limitations and educate advisors and investors on the value of the solution stand to gain market share and clients as adoption grows.
 Source: PWL Capital Insights, April 13, 2022
 Source: ibid
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