Personalized indexing, or direct indexing, has dominated headlines over the past few years. The strategy has been portrayed as both the ultimate financial planning tool for every investor and an overhyped and unnecessarily complex approach to retail investing.
The reality lies somewhere in the middle. Personalized indexing empowers advisors to deliver value to end investors through enhanced customization, including for tax situations, individual values or preferences, and complex financial situations. As every advisor can attest, clients often bring a unique financial picture to their planning, some more complex than others.
While current advisor adoption remains difficult to quantify, Cerulli Associates projects that personalized indexing is primed to grow at an annualized rate of more than 12% over the next five years – outpacing the research firm's expectations for mutual fund and ETF growth over the same period. Advisors undoubtedly face real headwinds to embrace new technology and introduce new financial planning approaches into their practice and need to understand how the benefits of personalized indexing outweigh the complexity.
Defining personalized indexing
Personalized indexing enables advisors to customize portfolios to their clients' specific preferences, goals, and circumstances.
Consider familiar pooled investment products like index ETFs, which are collections of securities in a single fund that seeks to track a given benchmark. With personalized indexing, investors directly own individual stocks in a separately managed account (SMA) that represents a chosen market-capitalization-weighted benchmark.
After an advisor selects a benchmark and applies a client's customization criteria — including tilts and environment, social and governance (ESG) preferences, or the exclusion of stocks or sectors to account for concentrated positions — sophisticated risk optimization runs behind the scenes to determine what a client should own to mirror the benchmark's risk and return characteristics. Often, an investor does not need to own every stock in an index to approximate its performance, and the exact number of securities held will vary based on the chosen index and the customizations applied. Tracking error will occur with any deviation from the benchmark, and advisors can help clients determine the acceptable amount.
Advisor-driven personalized indexing
Index mutual funds and ETFs have met investor needs for many decades, providing built-in diversification, low costs and a wide variety of investment options. For many investors, mutual funds and ETFs remain a viable option, helping them achieve long-term investment success at a low initial investment and for a reasonable fee. For others, personalized indexing can provide an additional level of customization necessary to meet their goals in the following ways:
Tax efficiency
Owning individual securities through personalized indexing creates opportunities for investors to benefit from the tax-loss harvesting of individual securities. The potential to receive tax benefits from the sale of securities at a loss typically applies more to high net worth and ultra high net worth investors. It also holds true for investors who have realized capital gains from other investments elsewhere in their portfolios.
Vanguard research has found that more frequent screening for individual security tax-loss harvesting opportunities leads to materially higher and more consistent tax benefits for investors. For an investor with extensive recurring capital gains, these differences can increase tax-loss harvesting alpha from 20 basis points to well over 100. Of course, tax-loss harvesting always involves certain risks, including the possibility that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. It could also have unintended tax implications. Prospective investors should consult with their tax or legal advisor prior to engaging in any tax-loss harvesting strategy.
Customizing ESG preferences
Advisors can use personalized indexing to tailor portfolios for clients that reflect their personal definitions of ESG and socially responsible investing (SRI). Leveraging exclusionary criteria (e.g., eliminating exposure to carbon emissions or weapons) or using positive impact tilts (e.g., overweighting companies with diverse board composition) offers clients personalized portfolios that reflect their individual preferences.
ESG portfolios are subject to ESG investment risk, which is the chance that the stocks or bonds screened will underperform the market as a whole or, in the aggregate, will trail returns of other portfolios screened for ESG criteria. The data provider's assessment of a company, based on its level of involvement in a particular industry or the provider's own ESG criteria, may differ from that of other portfolios or of the advisor's or an investor's assessment.
As a result, companies deemed eligible by the data provider may not reflect the beliefs and values of any particular investor, and certain screens may not exhibit positive or favorable ESG characteristics. The evaluation of companies for ESG screening or integration is dependent on the timely and accurate reporting of ESG data by the companies. Successful application of the customized investment strategy will depend on the data provider's proper identification and analysis of ESG data.
Factor tilting
Factor tilts may be appropriate for clients seeking outperformance. For example, some clients may believe in increasing exposure to certain value or quality characteristics of companies. Personalized indexing makes it easier to over- or underweight factors to express conviction in a factor strategy.
Personalized indexing always introduces some level of tracking error and investment style risk, and factor tilting is no exception. Returns from the types of stocks selected could trail returns from U.S. stock markets, or poor security selection could cause underperformance relative to benchmarks or funds with a similar investment objective.
Completion portfolios
Some investors have legitimate challenges to establishing and maintaining portfolio diversification, even when working with an advisor who believes in diversification. Diversification does not ensure a profit or protect against a loss, but many advisors seek to minimize risk by helping their clients construct balanced portfolios.
Consider a client with a large, concentrated position in equity compensation from a current or previous employer. Personalized indexing provides the opportunity for advisors to build tax-efficient portfolios around these existing positions. Additionally, advisors can transition these positions over time to minimize the tax obligation while continuing to achieve the desired investment exposures.
Behavioral coaching
As discussed earlier, any deviation from indices through direct indexing — including tilting away or toward factors, excluding securities, industries or sectors and tilting toward values-based criteria — comes at the expense of higher tracking error, and all investing is subject to risk, including possible loss of principal.
Advisors should prepare to help investors manage the implications of higher tracking error through behavioral coaching. Advisors can determine the amount of tracking error appropriate for a given client by assessing the portfolio risk appetite of the investor and the portfolio's intended versus unintended deviation from the index. Even with these advice interventions, there is no guarantee that any particular asset allocation or mix of funds will meet investment objectives or provide a given level of income.
Adding to the advisor's toolbox
Advisors continue to play a critical role in investors' success, even against a backdrop of new technologies and approaches that promote self-directed investing. Introducing solutions to help investors meet their sophisticated planning needs gives advisors a way to demonstrate their alpha in an increasingly challenging environment. Personalized indexing can be a powerful tool to craft tailored investor portfolios, deliver highly customized planning and steward clients' investment success.
