Better than 5,000 wealth management industry participants arrived in Huntington Beach, California this week for the Future Proof Festival. No word yet on Canadian attendance, but if Q Wealth Partners’ fifth annual Canadian Lounge was any indication, the sun-drenched event topped last year’s estimate of 300.
It was good to talk shop (rather than politics) with American friends and colleagues. The event served as a well-timed reminder of how much we share in common.
Still, it’s fascinating to spot the differences. One of the topics up for discussion at the FTSE Russell booth was a new piece of research released in advance of the conference. Surveyors spoke to 400 U.S.-based advisors about direct indexing, a strategy that allows investors to replicate and customize an index by owning the underlying securities directly.
It’s very much a mainstream offering south of the border — 83% of advisors told researchers that they are currently using direct indexing (41%) or plan to do so in the year ahead (42%). That’s up from 76% a year ago. The strategy dates back more than 30 years.
Much of the appeal has to do with U.S. tax law, which lets investors harvest losses on individual stocks even if the overall index has risen. Direct indexing allows investors to own the shares directly and use realized losses to offset capital gains.
“Tax is the No. 1 driver,” said Adam Gebler, head of wealth for the Americas, FTSE Russell in an interview Tuesday. Direct indexing is growing in popularity, both in terms of percentage of assets under management and the amount being invested.
Canadian tax law offers less flexibility. While the Internal Revenue Service allows investors to track the cost base of individual tax lots, the Canada Revenue Agency generally requires purchases of the same security to be averaged into a single adjusted cost base. That makes direct indexing less powerful, relative to the U.S., as a tax-loss-harvesting strategy here.
Still, the strategy can add value. A client enrolled in an employee share purchase plan, for example, may want to own the TSX composite without overloading on their company stock.
“They can just exclude that security,” Gebler said. “You can do that for whole sectors or industries.”
Canada’s turn?
A pair of Canadian direct-indexing announcements last year may indicate a developing market.
In March, Envestnet’s QRG Capital Management, Inc. asset management unit launched what it called Canada’s first model-traded direct-indexing solution held within a unified managed account. “We believe this innovation will redefine the way Canadian investors access tailored wealth management solutions, bringing them greater control, efficiency and flexibility,” said Michael Featherman, head of investment consulting & distribution at Envestnet in a release.
In October, Wealthsimple announced a package of upgrades including a direct-indexing portfolio it said would help clients “outperform the corresponding market index by 0.5% each year after taxes.” No advisor required.
Can direct indexing take hold in Canada?
“It’s a bit of chicken and egg,” said Paul Bowes, FTSE Russell’s Canadian country head in an interview Friday. “There are some large Canadian firms who have shared with me that they have teams who have looked at direct indexing in Canada.”
But until there are enough players in the segment, direct indexing is likely to remain a niche strategy.
“As recently as 18 months ago, a very senior individual told me they have looked at this a few times and have yet to see [an opportunity],” he said. “We’re quite a conservative industry. … The cost to be first mover is going to be extensive because there’s such an educational [requirement].”
There’s an obvious question for Canadian investors — why pay a direct-indexing provider when you can build the basket yourself?
“I have not come up with a good answer to that question,” Bowes said.
