Hold On. You’re Saying You Can Customize An Index?

You know what I miss? I miss equalizers on stereos. For all you millennials out there, there used to be a set of six, 10 or sometimes even more levers that allowed you to make adjustments to the sound quality of the music you were listening to, sometimes in very subtle intervals. You couldn’t change the recording itself, but you could, say, turn up the bass. Basically, you could take a mass-produced album and customize it so that it worked better for you. Man, I loved that.

But I’m not here simply to wax nostalgic about old records and old ways of doing things. Regular readers of this column know that I’m a firm believer in the power of technology and how it’s (mostly) improved the way we live our lives and interact with friends and colleagues — and, yes, build, manage and analyze investment portfolios. As I wrote in my last column, advances in technology have had a major effect on the construction of indexes, which are used as the basis and/or benchmark for many different types of investments.

In particular, the major effect we’re talking about today is something called direct indexing. Direct indexing essentially allows a wealth manager or adviser working with an individual investor to offer customized versions of existing indexes; essentially, the adviser fine tunes them based on any number of criteria to meet specific outcomes. One important difference between direct indexing and, say, mutual funds is that, rather than buying shares in a fund that tracks a particular index, investors directly own the individual securities within the index. Now, I know, this is starting to get a little complicated, but let me see if I can break it down for you.

Tell me what you want

Let’s take the example of an investor who’s looking to invest in a way that reflects her views on the importance of reducing carbon emissions or increasing diversity in corporate boardrooms … or both. Climate and ESG considerations are becoming increasingly important components of many investors’ goals. At the same time, our investor would like to have a way to seek lower risk, increase global exposure and work to reduce the tax impacts of her investments.

Once the goals are clear, the adviser can select a particular index, and customize it based on what the client wants to achieve. In the end, an adviser can help deliver an index that is specifically tailored to the investor.

Let’s not make this too taxing

I feel like most of the customizations I included in the example are pretty straightforward: climate and ESG, lower risk and investing around the world. But we should spend a little bit of time on the tax-management part and something called “tax optimization,” which really is just a way of achieving a variety of investment objectives at the same time in the most efficient way possible, including tax considerations. Tax optimization can come in very handy since many advisers take care of tax-related issues in a very manual, sometimes cumbersome way.

Tax optimization is an efficient, rules-based method to minimize taxes by offsetting portfolio losses against portfolio gains. The tax optimizer also works efficiently by not trading in many cases, as a result of avoiding unnecessary taxes and trading costs. Of course, in our example, tax efficiency is just one of the investor’s goals, and will be balanced against her overall strategy. All the while, the investor maintains exposure to the index of her choice, which in turn helps her work toward achieving her investment objectives.

Could this be the great equalizer?

The truth is, I could provide any number of examples of what different forms of direct indexing could look like, with as many or few variables or goals as you can imagine. And that’s the point: The approach is based on an index that is selected, customized and personalized for the individual investor by a financial adviser.

I’ve written before about how one of the great advantages technology has brought is accessibility. That which was once the domain of a select, wealthy few is now available to a much wider audience. Direct indexing is no exception. In fact, in many ways it brings more of us an updated, index-based version of something called separately managed accounts, which most people outside the investment industry who are not the select, wealthy few may never have heard of. I won’t go into what they are here, because it’s really only somewhat related to what we’re talking about. And the point is that direct indexing does for investors what my old stereo’s equalizer did for me. I didn’t need to be a sound engineer to make the albums in my vinyl collection sound exactly how I wanted.