Custom Indexing: Tailoring Indexing’s Potential to Your Objectives

Even as indexing’s popularity continues to grow, many institutional investors are seeking to better tailor it to their specific needs. For some, that means turning to custom indexing, in which an investment portfolio is aligned to an index that’s been fully customized to their specifications. To find out how custom indexing works—and what institutional investors should know about it—Chief Investment Officer spoke recently with a trio of indexing experts from Invesco Ltd.’s Invesco Investment Solutions unit: Brian Hartigan, global head of index implementation and passive investments; Mo Haghbin, chief commercial officer and chief operating officer; and Vincent de Martel, head of North America client solutions.

CIO: What’s driving institutional investors to look beyond traditional indexing—and how is custom indexing evolving to meet their needs?

Mo Haghbin

Mo Haghbin: Institutional investors are looking for efficient ways to outperform traditional indexes or avoid risks. Early approaches to custom indexing focused on simple style tilts that provided exposure to a single broad factor, such as growth or value. As the strategy matured, we started to see approaches that incorporated multiple factors and made indexing less a pure beta proposition and more a tool for chief investment officers to think holistically about how they source returns.

CIO: How is Invesco applying this multi-factor approach to indexing?

Haghbin: A lot of asset managers provide access to a multi-factor index in which all factors are equally weighted. That can deliver good outcomes over a 20-to-30-year time horizon, but it can be challenging over shorter time periods. We’ve designed a more dynamic approach to factor allocation which takes into account the impact of economic conditions on shorter-term returns. We incorporate rules into our custom indexes that reflect expected return variations across four different economic regimes—recovery, expansion, slowdown, and contraction. Our rules will favor cyclical factors when economic growth is below trend but starting to accelerate, for example, and momentum factors when growth is above trend and accelerating. In summary, it’s a rules-based approach to delivering active-investment concepts through a passive implementation—and a very predictable, transparent way to deliver the exposures an investor wants.

CIO: How are those rules actually implemented in a broadly diversified portfolio?

Haghbin: It’s a data-intensive process. Suppose we’re developing a custom indexed portfolio based on the Russell 1000, a common benchmark for large-cap stocks. We employ a bottom-up approach in which we score every security in that index in terms of multiple factors, such as volatility, quality, profitability, cash on hand, and cash flow, just to name a few. We then apply our security selection rules in accordance with those factors, which over time will result in tactical tilts to the portfolio. Of course, we rebalance on a regular schedule just as you would with any traditional index fund. The net result is that rather than making active decisions on generic building blocks—taking a momentum index, a value index, and a quality index and bringing them together under a top-down asset allocation standpoint—we’re creating portfolios at the stock level using a fixed set of rules and insights.

We follow the rules like any other index. But we think this is actually one of the clear advantages of an index-based approach. It takes emotion out of the equation.”
Mo Haghbin, Chief Commercial Officer and Chief Operating Officer, Invesco

CIO: Can you adjust asset allocations based on your outlook on the markets?

Haghbin: We’re not in the business of forecasting. We follow the rules like any other index. But we think this is actually one of the clear advantages of an index-based approach. It takes emotion out of the equation.

CIO: What would you say to a CIO who argues that the key to indexing is exactly the opposite of what you’re doing—that it should be a purely passive rather than active strategy?

Vincent de Martel

Vincent de Martel: We contend that choosing a standard index is really an active decision as well, for two reasons. First, it’s an asset allocation decision. Second, the way an index is constructed ultimately drives the selection of securities and, in some cases, the countries or regions in which an indexed portfolio will invest, with material ramifications. Take the MSCI ACWI ex USA global equity index, where China now accounts for 12% of the index’s assets—up from 7% just four years ago when MSCI started to include China domestic shares in that benchmark. Some investors might not want that much exposure to China, but are subject to the decisions the index provider makes—decisions that, at the end of the day, are active decisions.

CIO: How else might investors get something other than what they bargained for when they choose a fund that tracks a standard index?

de Martel: Let’s think about investors who choose a broad market index—we’ll use the Russell 3000 as an example—because they think it will give them exposure to the entire market. The numbers show that’s not always the case. It’s true that the Russell 3000 is an all-cap index; it includes all the large-cap stocks in the Russell 1000 and all the small-cap stocks in the Russell 2000. But those small cap shares represent only about 7% of the Russell 3000, suggesting they have little meaningful bearing on its performance. An investor who wants to benefit more significantly from the diversification benefits of small-cap stocks could find it easier to get that exposure through a portfolio managed to a custom index.

CIO: How has your multi-factor custom indexing strategy performed in the real world?

Haghbin: We launched the strategy in November 2017. Looking at annualized excess returns since then through October 31, 2021, we’ve outperformed an equally weighted strategy significantly—by more than 700 basis points (bps). Relative to the market, we’ve generated an excess return of about 258 bps while taking pretty close to the exact same risk—slightly higher risk, but very de minimis.

CIO: Investing with sensitivity to environmental, social, and governance (ESG) issues is becoming increasingly popular. How is custom indexing relevant in the ESG space?

de Martel: A lot of the conversations we’re having with institutional clients right now are focused on how best to incorporate ESG factors into their portfolios. The construction methodology of an index has big impact on its sensitivity to ESG factors. We see custom indexing as low-hanging fruit for ESG investors, given its cost-efficiency and its ability to be tailored to an investor’s specific ESG strategy.

CIO: What should a CIO look for when choosing an index manager?

Brian Hartigan

Brian Hartigan: Whether you’re going to be managing a portfolio against a traditional index or a custom index, you want someone with a dedicated indexing team that can act in an advisory capacity to help you navigate your specific needs. We sometimes see asset managers merging indexing into their equity or fixed-income departments, but we think that can be a mistake. Running an index takes an incredible amount of specialized expertise and attention to detail. Your team has to understand what the index rules are, whether they are tradeable, what the trade-offs might be if they aren’t, and how those trade-offs can be managed. You can have the greatest index design in the world, but if it’s not tradeable it would just be an index, not an index fund.

Automation is crucial, including systems to scrub and validate data, but so is expert human oversight because there will always be curve balls and nuances that must be dealt with.”
Brian Hartigan, Global Head of Index Implementation and Passive Investments, Invesco

CIO: How can index management impact performance?

Hartigan: Index management capabilities are critical to avoiding potential landmines and reducing tracking error and trading expenses. Cash management alone, including how you manage execution policy, dividend accruals, cash projections, currency repatriation, corporate actions, and the like, can have a big impact on performance. Being able to manage rebalancing at scale also is an important skill, especially when there are extraordinary flows of money into or out of a fund. Your indexer needs to be extremely organized and well supported by infrastructure and technology. Automation is crucial, including systems to scrub and validate data, but so is expert human oversight because there will always be curve balls and nuances that must be dealt with. Especially with custom indexing, index management isn’t a generic science. It’s specific to each client’s constraints, objectives, and strategy.

CIO: What’s your takeaway message for CIOs who might be thinking about custom indexing?

Haghbin: We’re trying to solve what every CIO struggles with, which is that they may outperform over a 30-year horizon, but they are evaluated over one-, three-, five-, seven-, and 10-year periods. During those periods, they are on the hook to the investment committee if they significantly underperform. We’re giving CIOs the ability to adapt and adjust their factor allocations, just like they would industry sectors or countries or regions, which we believe can be extremely positive and beneficial.

Learn more about Invesco’s index management strategies that may help you meet your investment goals.

All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment-making decision. As with all investments, there are associated inherent risks. This should not be considered a recommendation to purchase any investment product. This does not constitute a recommendation of any investment strategy for a particular investor. Investors should consult a financial professional before making any investment decisions if they are uncertain whether an investment is suitable for them. Please obtain and review all financial material carefully before investing. The opinions expressed are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Past performance is not indicative of future results.

All information is sourced from Invesco and as of 10/31/21 unless otherwise stated. Invesco Advisers, Inc. 2021