The term “direct indexing” is often used to mean two completely different things:
- index generation: Creating a custom (sometimes personalized) index.
- portfolio management: Trade so that a portfolio tracks this index over time.
If #1 is a recipe, #2 follows that recipe using (possibly limited) ingredients.
index construction
An index is just a set of securities with different weights, often chosen according to some technique such as market cap weighting, industry constraints, liquidity, and so on. Direct indexing is, or should, refer to a case where a portfolio contains the individual index constituents rather than a fund (usually ETF) that tracks that index.
There are many ETFs that track well-known indices. If I create an index on the fly, no ETF will track it because (a) it won’t be published so nobody knows what’s in it, and more importantly, (b) no ETF issuer will create an ETF for it if there is no demand. However, anyone can create their own index and build portfolios that replicate it. With DI, the lack of tracking ETFs is no longer an impediment.
Several companies are involved in creating custom indexes, usually from scratch, but sometimes by modifying an existing index. A customer’s personal preferences and/or ESG scores can also be taken into account in the design.
portfolio management
The Exit The index construction process becomes one Entry to the portfolio management process, the objective of which is to track this index through trading over time.
In some cases this is easy:
- If we start with $100,000 in cash, buying all the constituents with their index weights will track the index perfectly.
- We may not have to do anything for the next few days. This is the case with stock indices denominated in fixed stocks (almost all, to the author’s knowledge), where price movements cannot cause the portfolio to become unbalanced.
However, it can quickly become complicated. Examples:
- Cash proceeds from the sale of a removed stock cannot be invested in a “perfect” portfolio if some stocks have purchase restrictions (e.g., to avoid a wash sale).
- What happens when a stock’s ESG score falls? The sale improves the portfolio’s ESG score, but taxes may apply. It’s a compromise.
- If a custom index is based on a known published index and that index decreases or decreases a stock’s weight, the same tradeoff applies.
The greatest complexity here is evaluating the tradeoffs (tracking, taxes, ESG, transaction costs, holding costs, expected returns, etc.) that are subject to constraints.
Summary of differences:
frequency: Robo-advisors typically assess whether a portfolio should be traded on a daily basis, even if actual trading only needs to occur every few days. Human Advisors can do this on a quarterly basis. In any case, creating a custom index requires customer involvement, and they don’t want to deal with it every few days.
Requires customer inventory: In practice, a custom index will not (and should not) include a client’s other holdings. Whether a customer already z. B. AAPL owns the total amount he owns should own should be the same. However, the portfolio management needs to know the holdings of the customers in order to achieve the best possible portfolio by buying or selling.
Subjective: Custom indexing involves people’s personal values, which by definition is subjective. Portfolio management is objective. One has to enter many parameters to specify subjective aspects such as the index to be tracked (regardless of how it was created) or how much a client cares about tracking versus tax efficiency. However, given these parameters, there is only one best answer.
automation: Anything subjective cannot be fully automated as it requires human intervention.
Front End Requirements: A human (consultant or possibly investor) needs to try different values and examine the results: For example, if all stocks with an ESG score of 6 or less are excluded, does that leave too few stocks? Conversely, although a human can view the order proposals of a portfolio management system, this is not always necessary; The orders can simply be sent for execution. This is the case with robo advisors.
performance/speed: If index creation takes 0.1 or 1 second after clicking a button, no human will notice. However, when hundreds of thousands of accounts are evaluated for trading each day, this difference adds up.
techniques: Optimization can be summed up as “minimize something that is constrained”. The complexity of mathematics and software comes from juggling competing goals. Index construction may include such constraints (e.g. no more than 20% in an industrial sector) but need not include minimization. I can create a custom index simply by taking the S&P 500, underweighting the three stocks I don’t like, and normalizing all weights to add up to 100%.
In summary, direct indexing involves a sequence of (at least) two distinct logical steps. We hope this article clarifies this difference.
Iraklis Kourtidis is the founder and CEO of Rowboat Advisor, which develops investment software for separately managed accounts with a focus on tax efficiency and direct indexing. He also developed the first fully automated version of direct indexing for the automated investment service Wealthfront in 2013.
