The asset management industry is seeing a significant shift as investors increasingly demand customized indexes tailored to their specific investment objectives.
With customized indexing, investors own the actual securities that make up an index and hold them in a separately managed account (SMA). Unlike mutual funds and exchange-traded funds (ETFs) that are commingled into a single vehicle, SMAs offer investors the flexibility to maintain similar exposure as a targeted index or construct a customized portfolio that reflects their investment goals, values, and needs.
One of the main drivers of this growing demand is tax-loss harvesting, which can generate as much as 2% in annual tax alpha. Additionally, customized indexes can be used to manage currency risk, eliminate specific exposures, and create bespoke investment strategies based on an investor’s values.
Direct indexing is an emerging popular solution for asset managers looking to take advantage of tailored investment strategies by directly purchasing the underlying securities in an index, which offers greater flexibility and customization and reduces dependencies on large third-party index providers. These capabilities typically has been available to institutional and high-net-worth investors but is now becoming more accessible to retail clients through proprietary solutions from asset managers and a wave of acquisitions.
Benefits of tax-efficient strategies to generate tax alpha
Tax lot harvesting is a tax-efficient strategy that involves selling investments that have decreased in value to offset gains and reduce taxable income. In direct indexing, tax lot harvesting involves selling individual securities in the portfolio that have experienced a decline in value and replacing them with similar securities to maintain the overall exposure of the index.
For example, let’s say an investor has a direct index portfolio that includes shares of two companies, Company A and Company B. Company A has experienced a decline in value, while Company B has increased in value. To harvest the tax loss, the investor would sell the shares of Company A and replace them with similar securities that maintain the exposure of the index. The loss realized from the sale of Company A’s shares can be used to offset gains or reduce taxable income while maintaining the overall exposure of the portfolio.
Enabling targeted investment strategies
To achieve customized indexes, asset managers can exclude certain sectors or companies, such as when a family has significant exposure to a company in a particular sector and wants to reduce or eliminate exposure to that sector for a given benchmark. To construct such a custom benchmark, the investor would first need to identify the securities they wish to exclude from the index. This process involves reviewing the existing index composition and identifying the relevant sector and company codes. Once the securities to exclude have been identified, the asset manager can construct a custom benchmark that includes all other securities in the index but excludes the identified securities.
Four data challenges of direct indexing
Creating customized indexes presents several data challenges that must be addressed to ensure their success.
- Data quality
High-quality data on individual securities, including price data, reference data, and corporate actions, is crucial for the index modeling, maintenance, management, and reporting. Ensuring the accuracy and completeness of this data can be difficult, especially for smaller or less liquid securities. - Performance attribution
Measuring the performance of a customized benchmark or index can be complex, requiring accurate, near real-time data on individual securities and the ability to measure the impact of security selections on portfolio performance. - Rebalancing
Direct indexing requires regular portfolio rebalancing to maintain the desired portfolio characteristics and performance, which can create data challenges related to transaction costs, tax implications, and market liquidity. - Data privacy and security
Ensuring data privacy and security is also a significant challenge, as direct indexing solutions often involve sensitive financial information and proprietary strategies.
To overcome these data challenges, asset management firms need to adopt new and improved tools, technologies, and processes that can facilitate an efficient client experience, including:
- Accurate, up-to-date information on the security universe
- Transparent and robust index models
- Precise execution to continuously align to investment goals and risk tolerance
- Automated compliance rules, flexible bespoke reporting, and seamless data integration across systems
Deploying direct indexing for your business
Direct indexing is a way for asset management firms to access additional revenue streams. Like any new business channel, the strategy and approach for enablement must be aligned with the overall business strategy and organizational capabilities. Some firms choose to outsource direct indexing, an option that can be quick to deploy and that offers the benefit of another firm’s technology, infrastructure, and experience.
On the other hand, it can lead to a loss of control during the investment lifecycle, and it can be costly. Many organizations are now looking to enable direct indexing solutions in-house, either by building from scratch or utilizing white-label software solutions. Regardless of the approach, integrating high-quality, trusted data into the direct indexing solution is essential for efficient and effective delivery and service to clients.
Grandview Analytics is a consulting firm staffed by financial industry experts who specialize in helping asset management firms overcome data challenges and enable scalable technology solutions. Grandview helps firms implement new operating models, automated compliance rules, flexible bespoke reporting, and data governance programs that can support the deployment or improvement of your direct indexing efforts.
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