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Create, add, delete: Is custom indexing the next big frontier for investors? Editor's Views

Emma Rapaport  |  09 Jul 2021Text size  Decrease  Increase  |  
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When I was a late-teen, I worked at a café along Bondi's Campbell Parade. This woman would come every week and order the chicken salad – hold the chicken please. As a surly teenager, I thought this was ridiculous. It took all my self-control to not roll my eyes and tell her to order a different salad.  Now, I get it. She craved all the other ingredients – the crunch of the cos lettuce, the creaminess of the avocado and the zesty herb dressing – but couldn't stomach the chicken.

Buying exchange-traded funds (ETFs) can feel like this. When we purchase a fund, we instantly gain access to hundreds if not thousands of individual securities (or "ingredients"), but we must take everything. There's no hold this, or can I swap this out for that? ETFs have their benefits – instant diversification, low cost, low minimums, direct access to global markets – but also drawbacks. For investments that give you access to thousands of stocks, you get surprisingly little choice.

This could all change with a growing global trend called "direct indexing". Direct indexing allows investors to construct a custom portfolio that mirrors the composition of an index. Unlike an actively managed fund where a manager selects securities based on his or her investment philosophy, the starting point for direct indexing is an index like the S&P/ASX 200 or the S&P 500 from which securities are removed. But unlike an ETF, direct indexing purchases the individual securities that make up an index, rather than a unified product. It is the purchase of individual securities that give investors the extra flexibility to customise their portfolio.

Direct or custom indexing is not a new concept. Big institutional funds have been building their own indexes for decades. But declining costs and widespread fractional trading have recently begun moving direct indexing into the mainstream. Historically, if you wanted to replicate the S&P 500 as a retail investor – buy 500 stocks – it would be incredibly expensive. Back of the envelope calculation…500 trades at $10 a trade equal transaction costs of $5,000, and that's not a one-off. But trading costs have come down so low in the US, zero for some brokers, that cost is no longer a hurdle at any order size. Fractional trading – or buying a fraction of a security – is widespread in the US where the minimum entry for some mega-cap stocks is in the thousands. Without this feature, it would be very difficult to replicate an index if your starting amount was $10,000.

So, why is this the next frontier? Shaun Parkin, managing director of family office consulting firm Hall Road Investments says he sees lots of clients compromise their ESG-beliefs when they invest in products like ETFs. Direct indexing means they can 'hold the chicken'.

"With ETFs, you're getting an index, but you are beholden to that index," he says. "You don’t have any say in the way it’s set up. Sub-scale direct indexing means investors can get index-like exposure but customised, allowing them to incorporate environmental, social and governance (ESG) factors, religious beliefs or impact requirements."

Parkin acknowledges the raft of ESG ETFs on the market today but says investors are still bound to the provider's definitions. "I'm not saying that's a bad thing because coming from an index fund issuer myself I understand the work analysts like MSCI do, but if I'm looking for higher tracking error, I want to have a base which is the ASX 300 but I want to be able to have my own red flags on particular stocks or sectors. At the moment I can't do that."

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Selection

There are risks to being beholden to an index's methodology. The rebalance of the Russell 2000 Value Index added meme-names GameStop and AMC after their meteoric rise helped them qualify for the market capitalisation index. The top holdings of a US Vanguard ETF which tracks this index now includes GameStop and AMC Entertainment – two stocks caught up in the WallStreetBets meme showdown. iShares' decision to change the benchmark on two of its major global equity funds also reminds us that the rules can be changed.

Direct investing has also proved popular with US investors seeking tax-loss harvesting opportunities on individual index positions to offset taxes on capital gains. This involves selling investments that have incurred capital losses in order to “net out” or offset capital gains realised during the year. Investors can also avoid selling top gainers if they want to defer capital gains.

While direct indexing is just starting to take off in the US, alongside the rise of ESG, there is little (public) evidence of local efforts. Financial advisers are increasingly using separately managed accounts (SMAs) – a customisable portfolio where assets are selected by active managers but owned by the investor - but these don't feature custom indexing (yet). Direct-to-retail investors can only customise via asset allocation, with super funds like AustralianSuper allowing its members to select what portion of their retirement portfolio falls into stocks, bonds, infrastructure etc. Parkin believes platforms are best placed to do this work in, backed up their existing tech infrastructure.

While still a long way off, this is an exciting development for everyday investors. ETFs have democratised investing, allowing people like you and me to build diversified portfolios in a handful of low-minimum transactions. ETFs are a fantastic way to get a taste of investing without the anxiety of stock picking. But they are limiting, particularly for those with strong ethical or religious beliefs, or who already hold large positions in a mega-cap through stock options or inheritance. Direct indexing gives investors the best things about indexing and SMAs in one product.

There are of course trade-offs. Who knows how much any of this will cost? Customisation in other industries doesn't come cheap (as anyone who has worn a matching bridesmaid's dress knows). To make decisions, investors will also need access to high quality ESG data and research which is prohibitively expensive, and a way to track, manage and analyses their bespoke investment portfolios. The paternalistic side of me also wonders whether retail investors have benefited from the paternalistic nature of index-tracking – forcing us to take broad market-cap weighted positions. And as Parkin points out, we can fall victim to analysis paralysis, presented with so many options that we freeze up. At this stage, direct indexing feels like an adviser-led proposition – a service which is becoming less and less available to the average Australian. But never say never. I know this is something I'd want. And if the sheer number of people who have switched to SMSFs for more control is anything to go by, investors want it too.

For more on this topic, I recommend Morningstar's interview with investor, author, and popular podcast host Patrick O’Shaughnessy. His firm has released a custom portfolio builder for wealth managers.

All eyes on wages

A word from our resident central bank observer Lewis Jackson...

There were two things for investors to note from central bankers this week:

First, if you’re confused about inflation and its alphabet soup of acronyms - CPI or PCE – Governor Lowe gave a tip in a speech Wednesday: watch wage growth. The RBA doesn’t think we’ll see sustained inflation until wages lift. The bank has been predicting wage growth since 2013 and has been wrong repeatedly (see below). Once burnt twice shy, so the RBA is unlikely to tighten – raise rates or stop bond purchases – until they see this rise materially.

So cut through the noise and just bookmark the ABS wage price index.

RBA Wage Price Index Forecasts

Second, investors concerned about environmental risk got a nudge from the European Central Bank (ECB) on Thursday. The bank is taking a stronger stance on climate change and plans to limit its support programs for companies that don’t comply with EU climate goals. It’s part of a package of reforms announced following a strategic review. The decision is a world first and while it will take till 2024 to implement, it adds to the pressure being piled on polluters.

The half-year also means it's time for Peter Warnes' forecast ($). He writes that after 2020–21’s V-year - virus, variants, V-shaped recovery, vaccine, vaccination, and volatility – 2021-2022 is set to wrestle with an almost adjacent letter of the alphabet, the letter T. "The year will embrace issues involving timing, taper, tension, tantrum, transitory, temporary and others." Tune in for my interview with Peter next week. Also check out the equity research team's latest Quarterly Research Outlook, Q2 2021. The report discusses the key themes for each ASX sector and highlight analysts preferred stocks.

More half year reporting: 

Morningstar's complete midyear portfolio checkup

No losers in sight: The best performing equity funds of 2021

Biggest ETF launches this year (so far)

US market performance in 7 charts: Q2 2021

In Firstlinks this week, Graham Hand considers the downturn in the number of students taking economics in their final years of school and the big increase in young people investing (or trading) on the stock market. But where do they find their ideas? Maybe it’s time for investing education to be made compulsory in schools, he writes.

Finally, the Morningstar editorial team has a new, dedicated email address to receive all your comments, feedback, thoughts, tips etc. Email us at editorialAU@morningstar.com.

More from Morningstar:

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is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. Email Morningstar's editorial team at editorialAU@morningstar.com

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