The growing availability of trading data and information increasingly enables institutional investors and other market participants to improve existing portfolio models and build new ones. Providers and allocators can achieve any desired market exposure by matching sector characteristics and risk factors. This has allowed investors to move beyond traditional performance benchmarks and instead construct portfolios that reflect their unique investment theses.
“The increasing availability and sophistication of trading data and market information have fundamentally reshaped how public equity portfolios are constructed and managed,” says Michele Calcaterra, ECPI director at Confluence Technologies and a senior lecturer on entrepreneurial finance at Milan’s SDA Bocconi School of Management.
This trend is not new, but direct indexing has become more prevalent among investors in recent years.
“For at least a decade or more, allocators have been able to procure and employ the tools and strategies that enable them to build highly customized public equity portfolios using internal resources and, for at least two decades, using external resources,” says Eileen Neill, a managing director and senior consultant at Verus Investments.
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Direct Indexing
Institutional investors and the service providers that work with them have, in recent years, increasingly used custom indexes to personalize their exposures, such as tailoring portfolios to exclude stocks based on certain metrics, such as thematic conviction or policy constraints.
“Clients are seeking modular, tailored solutions,” says Nedelina Petkova, a senior investment director at NEPC. “Clients now use custom indexes to either amplify exposure to favored sectors, like artificial intelligence or clean energy, or to exclude sectors like tobacco, gambling or fossil fuels that may conflict with organizational values or regulatory guidelines.”
Direct indexing can allow allocators and providers to achieve precise public market exposure aligned with their desired risk-adjusted return objectives, says Melanie Pickett, head of asset servicing, Americas, at Northern Trust.
“We are seeing a shift toward direct indexing with adjustable exposures, as well as hedge fund separate account platforms where investors have more control over their exposures and liquidity, allowing them to risk up and down flexibly amongst strategies,” Pickett says.
Direct indexing has been around for more than a decade, but the market did not begin to significantly grow until 2018. Between 2018 and 2021, direct indexing assets under management rose to $350 billion from $100 billion, according to the CFA Institute.
“Trading data is now the Lego set of equity markets,” says Michael Ashley Schulman, CIO of and founding partner in multi-family office Running Point Capital Advisors. “Snap enough bricks together, and you can build any sector tilt, factor fiesta or thematic maze you like.”
Schulman says custom indexes can help clients avoid being overexposed to any specific stock.
“Imagine a $20 million client that already owns $7 million of Microsoft. When would I ever buy them any more?” Schulman says. “If I put them into a Nasdaq or SPY ETF like QQQM or VOO, 8.8% or 7%, respectively, is automatically going [into Microsoft]. Custom indexing can avoid that scenario.”
Informing Portfolio Construction
According to Paul Kenney, a senior vice president of client solutions at Syntax Data, passive strategies will continue to migrate toward direct indexing, as these strategies can diversify a portfolio while reducing the number of holdings.
“For example, a portfolio that holds indices invested in U.S. large-cap, small-cap and developed international equities may hold from 1,500 to over 3,000 individual securities, depending upon the indices selected,” Kenney says.
Direct indexing can streamline these portfolios, making them easier to monitor and manage. Kenney says investment managers will increasingly need to be tech experts as well, especially as AI-driven tools become more popular.
Direct indexing became especially popular after the COVID-19 pandemic, due to the global health emergency’s disruption of multiple sectors.
“If direct indexing was a ‘nice-to-have’ option for investors a couple of years ago, it is now looking more like a requisite tool in investors’ tool kit,” wrote Ben McMillan, CIO of IDX Advisors, in a CAIA blog post. “The combination of low forward-looking expectations for traditional asset classes, coupled with higher likelihood of continued volatility means advisers now don’t have the luxury of relying on a simple 60/40 allocation with an occasional ‘buy the dip.’”
Tags: benchmarks, Equities, indexing, Portfolio Management
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