Charles Schwab & Co. sets in motion monetization play for the ages to nudge zero-fee trading assets into fee-based accounts, a 'blurring' of lines between self-directed and advised assets - RIABiz

Charles Schwab & Co. sets in motion monetization play for the ages to nudge zero-fee trading assets into fee-based accounts, a 'blurring' of lines between self-directed and advised assets
News, Vision & Voice for the Advisory Community
News, Vision & Voice for the Advisory Community
CEO Walt Bettinger has repeatedly trumpeted next year's rollout of proprietary direct indexing as a sort of killer app that wins index and DIY assets alike
November 4, 2021 — 2:30 AM by Oisin Breen
Brooke’s Note: What is direct indexing? It’s essentially a model portfolio built around an index. What is a model portfolio? It’s essentially a rough draft of a managed account where the advisor or investor has the final say in what the final draft looks like. Using an index as a rough draft then tinkering with it based on convictions sounds like a core-and-explore investing strategy contained within a separately managed account (SMA). An investor could do much worse. It beats having a self-directed trading account and owning a few index ETFs around the edges of traded stocks as a belated anchor. So if direct indexing takes off because of marketing pushes of its make-your-own approach by companies like Schwab, it’s probably worth rooting for. What I don’t know is whether it’s as fun or empowering as self-directed investing. That may determine its success as a retail offering. But RIAs don’t expect to have fun. The process just needs to be good for the investor and for projecting the RIA’s investing philosophy. For that purpose, direct indexing might just play.
Charles Schwab Corp. executives are speaking out with uncharacteristic fervor about a 2022 rollout of “Schwab Personalized Indexing,” a direct-indexing product that could convert its $3.6-trillion of zero-fee-trading, DIY assets into a fee-based juggernaut. 
The change represents bold action because direct indexing will undoubtedly draw assets away from some of Schwab’s own lucrative products and services.
“Schwab has a long track record of being willing to cannibalize its own business. Will a larger share of future net flows maybe go to direct indexing? Yes,” says Chip Roame, managing partner of  Tiburon (Calif.) Strategic Advisors, which counts Schwab as a client, via email.
Schwab CEO Walt Bettinger spoke unreservedly at IMPACT 2021 and at Schwab’s Wall Street business update about how direct indexing may be the Westlake, Texas company’s long-awaited killer app.
‘[It] appeals significantly to individuals who are historically self-directed and index oriented,” Bettinger explained.
 “The idea that I’m going to take my money and simply turn it over to some fund or ETF and just trust that manager or trust that index is going to invest the way I want… I won’t go as far as to say those days are gone.
“I don’t think they’re gone, and maybe they’re not numbered, but they’re going to be challenged.” 
Bettinger said the lines between advice and self-directed are “on the cusp of starting to blur.”
The CEO’s comments addressed how Schwab will monetize brokerage assets de-monetized by taking commissions to zero, differentiate itself from Robinhood and other self-directed services, and compete for index assets with Vanguard Group and BlackRock. 
Bettinger went so far at IMPACT as to described direct indexing as a “freight train” barreling through the industry with a couched warning for RIAs to get aboard or miss the ride. 
In fact, Schwab’s 13,000 RIAs may turn out to be the quickest and best converts to its direct indexing, says Will Trout, director of wealth management at Pleasanton, Calif., consultancy Javelin Strategy & Research, via email.
“It’s where the opportunity lies. [It] empowers advisors to put their personal stamp on the client portfolio by incorporating factors, tilts and other vectors of customization,” he explains.
Unlike mutual funds and ETFs that many advisors and DIY investors use to build portfolios, direct indexing chops the product out of the chain and replaces it with software programmed to buy the stocks and bonds underpinning indices.
“RIAs, banks and others (BDs) are going to snap this up. They have to, given client demands for tax management, ESG, [and] customization.”
“Personalized service is a growth engine for RIAs,” says company spokeswoman Mayura Hooper.
“Their value proposition has been built on creating it and the technology, making personalization possible for high-net-worth investors, smaller investors, and the full range of RIAs as well.
“We all want to be a part of this,” she explains.
RIAs are in a growth mode will lap it up, Roame agrees. 
“When a financial advisor wins a new client, selling the entire existing portfolio to apply one’s new model–even if better–almost always creates a tax issue. Direct indexing is a solution,” he explains.
The service will take the form of a separately managed accounts service for taxable accounts, with a minimum investment of $100,000.
Initially, Schwab direct indexing portfollios will broadly match one of three indices, the Schwab 1000 Index that tracks the 1,000 largest publicly traded US firms, the S&P SmallCap 600 Index, which tracks small-cap stocks, and the MSCI KLD 400 Social, an ethical, social, and governance (ESG) index that tracks 400 ‘ethically sound’ companies.
Industry observers expect Schwab to add a larger number of index benchmarks once it finishes testing its in-pilot direct indexing service to iron out the kinks.
Schwab, which has yet to reveal the fees it will charge for direct indexing, but generally it carries an average 30- to 40-basis-point fee, according to Morningstar data.
That’s far higher than the average expense ratio of passive index funds, but it remains significantly cheaper than the average mutual fund fee.
The average fee for passive index funds stands at 13-basis-points today; whereas average mutual fund expense ratios stand at 59-basis-points for equities, and 42-basis-points for bond funds, according to data from the Investment Company Institute.
Bettinger is right to ascribe revolutionary potential to direct indexing, says Trout
“A boilerplate index can be licensed by anyone, but the creation of a personalized benchmark, or index drives sustained alignment to the client risk profile … [it] shifts the investor mindset from market tracking to long-term wants and needs,” he explains.
Indeed, Schwab can use direct indexing as a gateway product for investors not inclinded toward ETFs and the like, according to Hooper.
“Assets into direct indexing will come from a variety of sources and the personalization provided by direct indexing with tax loss harvesting, managing around concentrated positions, ESG or other exclusions, will appeal to a wide variety of investors — not just those who are index investors today,” she explains.
As such, direct indexing could lure hundreds of billions away from the $1.7 trillion in third-party funds it distributes.
That could spell bad news for third-party fund vendors, who could lose assets to broker-dealers with a strong direct-indexing business, says Trout.
“Direct indexing is a mega opportunity, [and] manufacturers may take a short-term hit,” he explains.
The laws of investor inertia will, nonetheless, have their say in this iteration, Roame counters.
“I see little chance Schwab ‘takes it all in house.’  Mutual funds still have $15 trillion to $20 trillion of AUM,” he says. 
Will all $1.7 trillion of the third party fund dollars shift to direct indexing? No, I don’t buy that, and I bet incremental money will still flow into those third party funds,” he says.
“If direct indexing at Schwab captures $200 billion to $300 billion [in] assets under its management (AUM) in a few years … an example of crazy good success,” then Roame projects $300 million to $750 million in annual revenues at roughly 15- to 25-basis- points.*
Yet Schwab need not evolve its business philosophy to accommodate direct indexing, according to Michael Wong, director of equity research and financial services North America for Morningstar Research Services.
“Over the past several years, [Schwab] has been an early mover into asset-based fee products, expanding its bank, exchange-traded funds, digital advice, physical franchise presence, and direct indexing,” he writes in an October analyst’s note.
Schwab formally began the process of launching its direct indexing service when it filed regulatory documents in late September. See: Schwab just filed to launch $100k-minimum direct indexing in 2022.
Schwab’s embrace of direct indexing is also part of a wider industry trend that dates back at least two years. See: With the action at Motif, Folio and Parametric as exhibits, RIAs may be on the verge of buying investments more like Spotify music, less like CDs.
Fidelity was the first of the major custodians and asset managers to move, investing in ESG direct indexer Ethic in September 2019. See: Fidelity Investments inks deal with $180-million startup.
Schwab then opted to outright acquire direct indexing software vendor, Motif, in May 2020.
Schwab executive vice president and chief digital officer Neesha Hathi described the deal as a move to “accelerate [Schwab’s] development of thematic and direct indexing … [for] retail investors and RIAs.” See: Schwab to buy Motif, and hire Hardeep Walia and much of his staff.
Soon after, in Sept. 2020, Goldman Sachs bought Folio Institutional, a direct indexing pioneer among RIA custodians. See: Folio Institutional finds its winning formula. Then Morgan Stanley bought Eaton Vance, and with it, Parametric. See: Morgan Stanley’s Eaton Vance deal yields a golden nugget: Parametric.
BlackRock ensured it had skin in the direct-indexing game by buying Aperio in November 2020. See: Aperio finds its white knight: BlackRock. A latter flurry this year saw J.P. Morgan buy OpenInvest this June, Franklin Templeton snap up O’Shaughnessy Asset Management and its Canvas direct indexing service, on Sept. 30.
Lastly, Vanguard Group gobbled up JustInvest this October. See: Vanguard Group buys Just Invest.
Schwab also launched fractional share trading for retail traders in May 2020, allowing investors to buy bundles of 10 stocks in five dollar increments it brands ‘Slices’. See: As Motif exits stock-bundle game, Schwab piles in with ‘Slices,’ fulfilling a pledge to offer free fractional shares.
Although a distinct service, commonly linked with mass-market trading of portions of high value stocks, fractional trading also allows portfolio’s managed through direct indexing to match index-tracking allocations far more precisely, regardless of the exact amount invested.
Yet several firms beat Schwab to the fractional trading punch.
Apex Clearing, and Folio long supported the process, Interactive Brokers then launched its own fractional trading service in November 2019, followed by Robinhood (December), and Fidelity (February 2020). See: With Robinhood pacing the new norm, Interactive Brokers outpaces Schwab in race to give RIAs free fractional-share trades.
Fidelity also just became the largest RIA custodian to hand RIAs fractional trading capabilities. It is the first to support real time market hours fractional trades, too. See: Fidelity gives RIAs real-time fractional trading despite little evident demand, while rival Schwab demurs, yet just filed to launch $100k-minimum direct indexing in 2022.
* Roame emphasizes, in email correspondence, that his “very rudimentary” estimated revenue projections for direct indexing, and the fees he ascribes the business line are wholly speculative.
Walt Bettinger | Bernie Clark
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