“Jaws: The Revenge”
“Caddyshack II”
“The Next Karate Kid”
“I Still Know What You Did Last Summer”
What do these films all have in common? They are among the worst sequels in the history of cinema.
In direct contrast to Hollywood’s lousy track record in churning out high-quality second 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”— technological trend lines that highlight slow and steady improvement over time in speed, convenience, costs, choice and personalization. These directional arrows of innovation usually point one way — up — and never look back.
Few investment concepts have seen such a societal perception shift as the index fund. Passive index investing has come a long way since being dubbed “
While indexing took a while to find its footing, once it took off there was no turning back. The initial benefits offered by index mutual funds are now obvious, providing investors a lower-cost and more transparent way to get market access without the high fees and risk of active management. ETFs improved upon the mutual fund structure from a tax-efficiency standpoint and opened the floodgates to a barrage of narrow and targeted indices that allowed investors to slice and dice portfolios with absolute precision toward factors, sectors, geographies, duration, credit quality and so forth.
The advent of direct indexing allowed for even more granular tax management as the index was owned through individual securities in a separately managed account, rather than in a commingled vehicle.
It’s hard to overstate the ramifications for investors. Strategies like direct indexing are no longer solely 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 all the things we know and love about index funds, custom indexing allows investors to personalize their own index portfolio across factors, ESG themes, geographies, sectors and at the individual security level.
The domino effect of commission-free trading
I remember it like it was yesterday. On Oct. 2, 2019, Schwab announced it would eliminate commissions on trades of individual stocks and ETFs. Like clockwork, TD Ameritrade, E*Trade, and Fidelity followed shortly thereafter. Whether you love Robinhood or hate it, there is no denying they were the spark that lit the fire of commission-free trading that is now the status quo.
Direct indexing was a direct beneficiary (no pun intended) of this seismic shift. Trading costs, already low at the time, could still add up significantly when trading accounts of hundreds of individual stocks. The removal of that friction opened this approach to an entirely new audience. What was once the domain of the ultra wealthy could now be offered at minimums of $250,000 or, in some cases, less.
ESG tailored to ‘me’
The proliferation of ESG funds in recent years has been a sight to behold. These funds go by many names — sustainable, socially conscious, responsible investing, etc. For investors seeking 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 offering consumers more choice, have also created confusion in understanding the nuance between funds and the holdings inside them.
When advisors present ESG solutions, a mismatch often exists between the client’s definition of ESG and that of the fund manager or index provider. For some, it’s a non-issue and a commingled fund checks all the right boxes. But a growing subset of investors prefers — and expects — to exert more control over what is excluded from and included in their portfolio.
Custom indexing also allows for greater coordination between a client’s portfolio and their tax planning and charitable giving endeavors.
Taxes down to a ‘T’
Previously, when holding a mutual fund or ETF in a taxable account, selling the entire fund was the only way to harvest a tax loss. With custom indexing, the gains and losses are unbundled at the individual security and tax lot level, which allows for deeper tax-loss harvesting opportunities.
Per O’Shaughnessy Asset Management, 31% of the stocks in the Russell 1000 delivers a negative return in a given calendar year, on average. By owning the individual stocks rather than an index fund, additional potential for “tax alpha” exists.
Custom indexing also allows for greater coordination between client’s portfolios and their tax planning and charitable giving endeavors.
The IKEA effect
Many of us know the feeling of building a piece of furniture from IKEA. Sure, the instruction manual made no sense, it was missing a screw or two and was a little bit wobbly at the end. But it was ours! We built it with our bare hands and an Allen wrench and take great pride in it, blemishes 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 impediment to long-term success. There’s something to be said about crafting a personalized portfolio, perhaps creating a higher likelihood that we end up sticking with our strategy through the inevitable ups and downs.
The revolution will be personalized
Mass customization, once considered oxymoronic, is upon us. Everyone is getting in on the action — Morgan Stanley, BlackRock, Dimensional, Vanguard, et al. Soon enough, custom indexing solutions will be table stakes for asset managers.
The long-awaited sequel to index investing is in theaters now. Phase one of index investing has been commoditized. The next leg of the revolution will be personalized. It will be fun to watch this evolution and growth unfold in the coming months and years.
Now it’s time to grab some popcorn, sit back, and enjoy the show!
