The next frontier? Investment portfolio customization 3.0

The dawn of direct investing has shaped a new trend in the investment management industry. Oliver Wyman estimates that custom solutions will reach $1.5 trillion by 2025, up from $350 billion in 2020, an increase of 329%! With rapid advances in technology, investors are quickly accepting the many advantages that direct investing offers over ETFs. In fact, many experts believe that direct investing will spearhead the next disruption to the investment management industry, much like ETFs did in the early 2000s.

A typical direct investment solution provides clients with a portfolio of stocks that tracks a stock market index. The shares are managed in such a way as to minimize capital gains tax. The direct-indexed portfolio can also take into account client values ​​by implementing restrictions based on ESG criteria. This means greater tax efficiency and greater ability to be personalized with specific values ​​alignment. But these are just a few of the ways wallets can be customized to meet individual client needs.

Portfolio customization solutions have undergone various innovations. First, we had a robo-advisor based on ETF allocations (which tracked indices based on market cap). Then came direct indexing (bypassing the ETF to hold stocks directly – but usually still tracking market cap-based indices) and the future is where index/rule-based portfolios and strategies are fully personalized (and based on direct investments in securities rather than ETFs).

Personalized investing as standard

Clients have highly differentiated sources of wealth and income and face specific risks unique to them. They have changing needs and personal preferences for managing their money. For example, many clients might consider reallocating their portfolio during a volatile market and opting for safer and less productive stocks. This is where personalized investment solutions come in.

As Tindeco CEO Michael Kaimakliotis says, “The future of investing is personalized.” While the demand for true customization is massive, until now it has only been limited to ultra-high net worth clients who can provide investment managers with investable assets in excess of $10 million. This was partly due to the lack of appropriate technology and partly due to the lack of appropriate expertise in the field of the managers involved.

“My biggest problem as a fund manager was too much client demand. We lacked the right technology to manage a lot of highly personalized portfolios. I had the budget but the technology just didn’t exist. We founded Tindeco to close this gap,” says Michael Kaimakliotis, CEO of Tindeco.

Recent advances in big data and machine learning are finally shedding light on emerging technologies that can enable investment managers to deliver highly personalized portfolios on a scalable economic basis. The future should bring a democratization of investment management with truly personalized solutions soon to be available to everyone.

The ability to have full control over the portfolio also allows investors to perform more aggressive tax loss harvesting strategies. This contrasts sharply with active portfolio management where more than half of portfolios receive no tax treatment. This is paramount since research shows that tax loss harvesting has the ability to increase portfolio returns by around 1 percentage point, which can accumulate over the long term.

A contrast with the past

Mutual funds and ETFs have been the dominant innovations in the investment management industry over the past five decades. They were based on simple mathematical models of investors and asset prices. These patterns were elegant and could often be solved by mathematicians with pen and paper. This was a key factor in their success at a time when high performance computing was still at an early stage.

However, all of these mathematical models were based on the fact that all investors were the same except for their willingness to tolerate “risk”. They also assumed that everyone would have the same notion of “risk”. For example, consider portfolio volatility over a fixed investment horizon rather than risk of shortfall, risk of loss, or asset-liability mismatches. The result of these models was that everyone had to buy and hold the same portfolio of funds plus an amount of cash that varied according to their risk tolerance. Unsurprisingly, this meant that the idea of ​​custom solutions was not a primary consideration.

However, the future will certainly be different as more clients turn to personalized investment solutions. According to a report by Morgan Stanley and Oliver Wyman, assets under management could reach around $1.5 trillion by 2025, up from $350 billion in 2020.

“I think there will be more competition and commercialization of direct indexing in 2022.” – René Bruer, CEO of Smith-Bruer Advisors.

The stiff competition, on the other hand, presents a new challenge with managing such personalized portfolios at scale and this is where rules-based portfolios offer a unique advantage over traditional investing.

In recent years, rules-based trading has grown in popularity due to its inherent ability to quantify whether an asset is investable based on a set of predefined principles. They can range from simple rebalancing rules to hedging strategies or sophisticated strategies to create a performance comparable to that of a hedge fund. It has the ability to achieve above-market net returns at low costs and under favorable risk conditions.

A platform designed to manage rule-based portfolios can essentially be automated to manage portfolios based on buy and sell rules. An index is the simplest rule-based strategy. The portfolio can also act as a custom index that a passive investment manager tracks or against which an active manager tries to generate alpha returns.

Simplified investment portfolio customization

Developing rules-based portfolios can seem like a daunting task for most investment managers. No-code portfolio management software can greatly simplify this task. These products allow business users and end customers to drag and drop and set up widgets that represent investment logic.

The ability to let private clients and investment advisors design systematic investment portfolios bridges the gap that used to exist between the world of traditional and quantitative investments. For this reason, there would appear to be strong signals that personalized, rules-based investment solutions are a catalyst for automated yet highly organized portfolio management based on specific client needs.

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