Quantifying the Impact of Direct Indexing

  • We apply five levels of customization to four developed-market equity strategies to quantify the impact of customization (or direct indexing).

  • As intuition suggests, customizations limit access to certain investment opportunities, and higher active share as a result of customization leads to higher tracking error versus the baseline strategy.

  • Educating investors about the impacts of customization should improve investment outcomes by reducing surprises and encouraging investors to stay the course.

Portfolio customization requires trade-offs. Adjustments to the weights of index constituents via a separately managed “direct index” will inherently change a portfolio, but how much does customization impact a portfolio’s performance and characteristics? Intuition tells us that broadly diversified portfolios will exhibit minimal impact from modest customization and that narrowly diversified portfolios will experience a material impact from significant customization. But what is the specific impact of popular ESG (environmental, social, and governance)-related customizations in some popular equity portfolio strategies?

In order to quantify the impact of customization (or direct indexing), we apply five levels of customization to four developed-market equity strategies. The sample portfolios we examine range from a broad capitalization-weighted portfolio to a relatively concentrated deep-value portfolio. Similarly, our customizations range from a light-touch exclusion of weapons, tobacco, and gambling companies to a restrictive 50% reduction in carbon intensity. The goal of our analysis is to help investors manage their expectations around customized portfolios by quantifying the impact on portfolio characteristics and portfolio performance.

Our Customizations

Individual investors have used separately managed accounts for decades as a way to lower their tax burden relative to a commingled vehicle, such as a mutual fund. Increasingly, investors are using separately managed accounts to align their portfolios with their personal beliefs. Investors can reduce exposure in their portfolios to companies they view unfavorably either according to individual company attributes or via a combination ESG measures.