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There is an old joke where a drunk loses his keys in a dark part of the street, but instead looks for them under a streetlight, because that’s where the light is. There’s a name for this concept: the “streetlight effect”.
The investment industry has traditionally placed a large emphasis on the past, although often the real interest is in the future. For example, an investing strategy may need to look at past correlations between asset classes, but always with an eye towards reducing risk in the future—under the assumption that such correlations are reasonably stable over time.
However, a lot of effort goes towards solely the past, even without an indirect focus on the future. Investment performance reports are such an example. Although it is interesting to see how an account’s investments performed, one cannot change the past. Moreover, unless there is reason to expect momentum or reversion instead of efficient markets (and there rarely is, for most investors), knowing how an investment performed will not affect any future actions.
Personally, as an investor, I care more about the future than about the past.
This inverted focus is rarely questioned, but has historically made sense. The main benefit of portfolio management has been higher returns, and it is impossible to show accurate future projections, since nobody knows which way the market will go. In a way, this is an instance of the streetlight effect: we look at past performance because it’s easier to create all kinds of reports (by industry, by asset class, etc.), even though it’s future performance that really matters.
However, given the shift toward direct indexing and custom portfolios that’s underway, there are now additional benefits: these include increased tax efficiency and enabling perform tax loss harvesting, and the ability to customize for ESG. It remains hard to answer the question “will this strategy outperform the benchmark?” Still, there are now several other forward-looking questions whose answers are less dependent on market direction. Examples:
1. Will this strategy be able to adhere to ESG preferences closely enough?
2. More generally, is a strategy correctly tuned to implement the desired tradeoff (often per client preferences) between tracking error, tax efficiency, and ESG?
3. Given a client’s specific situation (tax brackets, target allocation, expectation of future cash deposits and withdrawals, etc.), will there be a sufficient tax benefit from tax loss harvesting?
The reason is that these answers depend less on the direction of the market. For instance, No. 1 depends on the frequency and magnitude of changes in an ESG provider’s ratings. If those change often and by a lot, it will be hard for the portfolio to keep up. Similarly, if a client portfolio has too many exclusions or tilts, it is possible that, given the way a strategy is tuned, ESG will conflict with tracking the target, and become deprioritized.
In summary, the shift to direct indexing creates a different set of forward-looking questions, which can be answered without having to predict the market’s direction. This means that accurate future projections will become increasingly more important.
Iraklis Kourtidis is the founder and CEO of Rowboat Advisors, which builds investing software for separately managed accounts with a focus on tax efficiency and direct indexing. He also built the first fully automated version of direct indexing in 2013 for automated investment service Wealthfront.
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