Index Investing, the sequel: this time, it’s personal

“Jaws: Revenge”

“Caddyshack II”

“The Next Karate Kid”

“I still know what you did last summer”

What do these films have in common? They are among the worst sequels in the history of cinema.

In direct contrast to Hollywood’s poor track record of producing high-quality supporting acts, consider the world of index investing, which has fared much better. Index investing has followed what venture capitalist Josh Wolfe calls “directional arrows of progress” – technology trend lines that highlight slow and steady improvement over time in speed, convenience, cost, choice and personalization. These directional arrows of innovation usually point in one direction – up – and never look back.

Few investment concepts have experienced such a shift in societal perception as the index fund. Passive index investing has come a long way since it was dubbed “Bogle’s madness.” Today, these funds are the default investment option for millions of investors around the world, with approximately $11 trillion invested in US equity index funds today.

Although indexing took a while to find its footing, once it took off, there was no turning back. The initial advantages offered by index mutual funds are now evident, offering investors a cheaper and more transparent way to access the market without the high fees and risk of active management. ETFs improved the structure of mutual funds from a tax-efficiency perspective and opened the floodgates to a barrage of narrow, focused indices that allowed investors to slice and dice portfolios with absolute precision. based on factors, sectors, geographies, duration, credit quality, etc. .

The advent of direct indexing allowed for even more granular tax management, as the index was held through individual securities in a separately managed account, rather than in a mixed vehicle.

It’s hard to overstate the ramifications for investors. Strategies like direct indexing are no longer just for the rich, and all signs now point to an inevitable future where custom indexing (the next evolution of direct indexing) reigns supreme for all investors. In addition to providing everything we know and love about index funds, Custom Indexing allows investors to customize their own index portfolio across factors, ESG themes, geographies, sectors and level of individual security.

The domino effect of commission-free trading
I remember it like it was yesterday. On October 2, 2019, Schwab announced that it would eliminate commissions on individual stock and ETF transactions. Like clockwork, TD Ameritrade, E*Trade and Fidelity followed soon after. Whether you love Robinhood or hate it, there’s no denying that they were the spark that ignited the fire of commission-free trading that is now the status quo.

Direct indexing has been a direct (no pun intended) beneficiary of this seismic shift. Trading costs, already low at the time, could still add up significantly when trading accounts of hundreds of individual stocks. Removing that friction opened up this approach to an entirely new audience. What was once the domain of the ultra-rich could now be offered for as little as $250,000 or, in some cases, less.

ESG adapted to ‘me’
The proliferation of ESG funds in recent years has been a sight to behold. These funds go by many names – sustainable investing, socially responsible, responsible, etc. For investors looking to align their capital with their values, they can be a viable solution. The flurry of mutual fund and ETF launches with an ESG bent, while providing more choice for consumers, has also sown confusion in understanding the nuance between funds and the holdings they contain.

When advisors present ESG solutions, there is often a mismatch between the ESG definition of the client and that of the fund manager or index provider. For some this is not a problem and a mixed fund ticks all the right boxes. But a growing subset of investors prefer – and expect – to exercise more control over what is excluded and included in their portfolio.

Custom indexing also allows for better coordination between a client’s portfolio and their tax planning and charitable giving activities.

Taxes up to a ‘T’
Previously, when holding a mutual fund or ETF in a taxable account, selling the entire fund was the only way to reap a tax loss. With custom indexing, gains and losses are unbundled at the individual security and tax lot level, allowing for deeper tax loss harvesting opportunities.

According to O’Shaughnessy Asset Management, 31% of stocks in the Russell 1000 offer a negative return in any given calendar year, on average. By owning individual stocks rather than an index fund, there is additional potential for “fiscal alpha”.

Custom indexing also enables better coordination between clients’ portfolios and their tax planning and charitable giving efforts.

The IKEA effect
Many of us know the feeling of building IKEA furniture. Of course the instruction manual made no sense, was missing a screw or two and was a little wonky at the end. But it was ours! We built it with our bare hands and an Allen wrench and are very proud of it, imperfections and all.

This IKEA effect is a well-documented cognitive bias that notes the disproportionately high affinity we place on things we have created or assembled ourselves. As investors, our own behavior is often the biggest obstacle to long-term success. There’s something to be said for building a personalized portfolio, perhaps creating a greater likelihood that we’ll end up sticking to our strategy through the inevitable ups and downs.

The revolution will be personalized
Mass customization, once considered an oxymoron, is upon us. Everyone is in on the action – Morgan Stanley, BlackRock, Dimensional, Vanguard, et al. Soon, custom indexing solutions will be table stakes for asset managers.

The long-awaited sequel to index investing is now in theaters. The first phase of index investing has been trivialised. The next stage of the revolution will be personalized. It will be fun to watch this evolution and growth unfold in the months and years to come.

Now is the time to grab some popcorn, sit down and enjoy the show!