Index Investing as an Active Decision: An Exploration of Evolution and Customization

We explore how advancements in indexing solutions have allowed investors to tailor their portfolios according to their specific objectives or risk profiles.

KEY POINTS

What it is

We examine how index investing has evolved from basic market replication to a sophisticated tool, including opportunities for customization.

Why it matters

Investors may find that custom indexing approaches can help balance their unique goals with changing economic conditions.

Where it's going

As investors increasingly confront a complex array of market conditions, the ability to customize index solutions may offer strategic opportunities.

Index investing continues to evolve since its inception, from a rudimentary representation of market performance to a more sophisticated and integral component of institutional investment strategies. The broad acceptance and implementation of indexing are both now ubiquitous, making index funds and the decisions across benchmarks key inputs into asset allocation and portfolio construction. The evolution of indexing encompasses several key areas, including passive equity investing, fixed income investing, and more recently, index customization, which highlights an important shift in how investors approach the uses for indexing.

Evolving Approaches to Indexing

Traditionally, index investing was synonymous with passive equity strategies and funds that aimed to replicate the performance of well-known benchmarks such as the S&P 500 Index. As market dynamics have evolved, so too have the methodologies – the rules and design of indexes – and therefore the ways in which indexes are employed.

Fixed income indexing, for example, has gained traction as institutional investors recognize the benefit of incorporating cost-effective fixed income strategies within portfolios. This transition was marked by significant advancements in technology, enabling more precise means to measure and track fixed income markets. As a result, investors have increasingly sought out more tailored strategies that address specific market segments, align with risk tolerances, and allow for flexibility in response to changing economic conditions.

At the core of effective index investing is the critical decision regarding benchmark selection. The choice of benchmark can influence investment performance, making the indexing decision an active engagement rather than a passive one. Institutional investors may find that the benchmark indices originally chosen some years ago require reevaluation in light of methodological updates or evolving market conditions.. This reassessment is increasingly necessary as even seemingly minor methodology differences can result in unexpectedly different and non-intuitive outcomes.

Custom Indexing: Opportunities and Challenges

In this context, the advent of custom indexing has emerged as a timely and innovative solution, allowing investors to tailor their portfolios according to their specific objectives or risk profiles. Custom indexing presents a similar opportunity for asset managers and investors to develop bespoke portfolios that provide flexibility to pivot in response to a dynamic market. However, creating a custom index necessitates a thoughtful and meticulous design process to mitigate unintended risks and consequences associated with non-standard benchmarks relative to market-capitalization weighting schemes. Key considerations might include tilting towards specific investment styles, managing geopolitical risks, or ensuring optimal market exposures to align with the overall goals and objectives.

Furthermore, the dynamics of fixed income indexing underscore both its opportunities and challenges. Unlike the equity markets, which are comparatively straightforward to replicate, fixed income markets require a more nuanced approach due to the diverse structure of debt securities, number of issues, and liquidity constraints. Recent innovations within fixed income indexing includes the growing use of systematic and customized indexing. These approaches enable investors to tailor strategies that may focus on specific objectives, such as capturing incremental income while systematically selecting credits that may be undervalued using spread and default-based metrics. Regardless of the approach, these strategies require diligent monitoring to navigate the inherent risks associated with fixed income investing.

The journey toward designing and implementing a custom index begins with a clear understanding of investor’s objectives and framework for risk controls, and how passive strategies may complement the use of active ones within a portfolio. Successful outcomes often hinge upon collaboration between institutional investors and skilled asset managers who possess a deep understanding of index methodologies and portfolio implementation. A well-designed custom index strategy not only aligns with the overarching investment goals but also adequately addresses performance attribution, ensuring transparency and accountability.

Conclusion

The innovations in indexing represent an important evolution in the investing landscape that brings more power to investors. As investors increasingly confront a complex array of market conditions, the ability to customize index solutions offers a strategic advantage. By partnering with knowledgeable asset managers, institutional investors can exploit indexing tools to enhance portfolio performance while addressing specific needs that conventional indexing approaches might not fulfill.

IMPORTANT INFORMATION

Northern Trust Asset Management (NTAM) is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Northern Trust Asset Management Australia Pty Ltd, and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

Issued in the United Kingdom by Northern Trust Global Investments Limited, issued in the European Economic Association (“EEA”) by Northern Trust Fund Managers (Ireland) Limited, issued in Australia by Northern Trust Asset Management (Australia) Limited (ACN 648 476 019) which holds an Australian Financial Services Licence (License Number: 529895) and is regulated by the Australian Securities and Investments Commission (ASIC), and issued in Hong Kong by The Northern Trust Company of Hong Kong Limited which is regulated by the Hong Kong Securities and Futures Commission.

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Past performance is not a guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by NTAM. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Net performance returns are reduced by investment management fees and other expenses relating to the management of the account. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise. For U.S. NTI prospects or clients, please refer to Part 2a of the Form ADV or consult an NTI representative for additional information on fees.

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