Downsides of Direct Indexing: Tracking Error and Less Diversification

Direct indexing is a tricky proposition. A Research Affiliates report gauges the weaknesses of how different portfolio constructions, such as those omitting certain types of stocks from a traditional index, lead to different levels of tracking error and diversification.

The paper further examines how these stock-picking arrangements fare under an array of investing philosophies: a straight-up market cap index, one using fundamental measuring and others focused on value and deep value.

Direct indexing has found favor with institutions that seek to tailor traditional indexes to their own preferences, perhaps orienting them more toward tech or knocking out companies they deem undesirable for political or other reasons. The process seeks to create its own hybrid indexes, because investors form them, as opposed to the usual off-the-shelf index products for the S&P 500, Russell 2000, etc.

One variety of direct indexing is to exclude the so-called sin stocks: in weapons, tobacco and gaming industries. Another shuns fossil fuel stocks, the paper explains. Then there are portfolios constructed according to companies’ carbon intensity, which goes beyond merely snubbing fossil fuel producers. These focus on greenhouse gas outputs from all companies; a steel maker would have larger carbon emissions than a semiconductor outfit, for example.

The firm also measures the performance of four different types of funds that weigh companies by 1) market cap (much like the S&P 500 and other such legacy indexes do); 2) fundamentals (such as value, quality and so forth, an approach Research Affiliates helped pioneer); 3) cheap stocks (value); and 4) even cheaper ones (deep value).

On that scale, deep value has the highest carbon intensity (37.1% of the portfolio is composed of high emitters), trailed by value (30.1%), fundamentals (22.2%) and market cap (15.3%).

Excluding sin stocks doesn’t change portfolio carbon scores much, as weapons makers and the like are a small minority of the investing universe.

Overall tracking error, measuring how much the new portfolio differs from the underlying index, is greatest for the value and deep value ones (7.06% and 9.67%, respectively). The fundamentals have a 3.76% tracking error. The cap-weighted one, which mirrors the indexes, has 0%, of course.

The customization tends to create more concentrated, hence less diversified, collections of stocks. Carbon intensity portfolios are the most concentrated.

The report concludes that “investors need to understand the portfolio characteristics, expected risk, and expected returns of the strategies they are considering. Direct indexing is no exception.”