The Next Frontier? Investment Portfolio Customization 3.0

The dawn of direct investing has carved out a new trend in the investment management industry. Oliver Wyman estimates that customized solutions are expected to grow to $1.5 trillions by 2025 from $350 billion in 2020 – a 329 percent increase! With rapid advancements in technology, investors are quickly coming to terms with the many benefits that direct investing provides when compared with ETFs. In fact, many experts opine that direct investing will spearhead the next disruption in the investment management industry just like ETFs did so in the early 2000s.

A typical direct investing solution provides clients with a portfolio of stocks that tracks an equity index. The stocks are managed to minimize capital gains taxes. The direct indexing portfolio may also take account of clients’ values by placing restrictions based on ESG criteria. That means greater tax efficiency and higher ability to be customized with specific values alignment. But these are only a few of the ways in which portfolios can be customized to meet clients’ individual requirements.

Portfolio customization solutions have been through various innovations. First, we had robo-advisory based on allocations to ETFs (which tracked market cap based indices). Then came direct indexing (bypassing the ETF to hold stocks directly – but generally still tracking market-cap based indices) and the future is where indices / rules based portfolios & strategies are completely customized (and based upon direct investments in securities rather than ETFs).

Custom Investing as a Standard

Clients have highly differentiated sources of wealth and income and face specific risks that are unique to them. They have needs that are evolving over time and personal preferences about how their money should be managed. For example, many clients might consider reallocating their portfolio during a volatile market and opt for safer, less yielding equities. This is where customized investing solutions fare in.

As Michael Kaimakliotis, the CEO of Tindeco says, “The future of investing is custom.” Although the demand for true customization is massive, up until now, it was limited only for ultra-high-net-worth clients who could bring investment managers investable assets in excess of $10 million. This was partly due to the paucity of proper technology and partly due to the lack of proper domain expertise of the managers involved.

“My biggest problem as a money manager was too much client demand. We lacked the right technology to manage large numbers of highly customized portfolios. I had the budget but the technology just didn’t exist. We founded Tindeco to eliminate that gap,” says Michael Kaimakliotis, the CEO of Tindeco.

Recent advancements in big data and machine learning are finally bringing into light emerging technologies which can enable investment managers to provide highly customized portfolios on a scalable economic basis. The future is expected to bring a democratization of investment management with truly customized solutions soon to be available for everyone.

The ability to have complete control over the portfolio also enables investors to perform more aggressive tax-loss harvesting strategies. This is in sharp contrast to active portfolio management where over half of the portfolios do not receive any tax treatment. This is paramount since research shows that tax-loss harvesting has the ability to boost portfolio returns by approximately 1 percentage point, which can stack up in the long run.

A Contrast With The Past

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

However, all these mathematical models were based around 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, considering portfolio volatility over a fixed investment horizon rather than shortfall risk, drawdown risk or asset-liability mismatches. The result of these models was that everyone should buy and hold the same fund-portfolio plus an amount of cash which varied according to their risk tolerance. Unsurprisingly, this meant that the idea of customized solutions were not a main consideration.

However, the future is bound to be different with more clients gravitating towards customized investment solutions. According to a report from Morgan Stanley and Oliver Wyman, assets under management may reach an estimated $1.5 trillion by 2025, up from $350 billion in 2020.

“I believe there will be more competition and marketing of direct indexing in 2022.” – Rene Bruer, CEO of Smith-Bruer Advisors.

High competition, on the other hand, presents a new challenge with managing such highly customized portfolios at a large scale and that is where rules-based portfolios offer a unique advantage as opposed to traditional investing.

In recent years, rule-based trading has had a massive surge in popularity because of 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 performance comparable to that of a hedge fund. It has the ability to net market-beating returns at low costs and favourable risk conditions.

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

Simplifying Investment Portfolio Customization

Developing rule-based portfolios can seem like a tall order for most investment managers. No-code portfolio management softwares, can simplify this task to a great extent. Such products enables business users and end clients to drag and drop and parameterize widgets that represent investment logic.

The ability to let private clients and investment advisors design systematic investment portfolios provides a bridge across a divide that has existed between the world of traditional and quantitative investments. Because of this, it would seem that there are strong signals that point to rules-based, customized investment solutions being an enabler for automated yet highly curated portfolio management according to the specific needs of clients.

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