Within the multi-trillion dollar passive investment sector, a new trend in investing has emerged: Custom indexing.

Custom indexing is based on investment indexes that underpin standard passive investment strategies, but with an added degree of flexibility that allows investors to invest based on their own personal circumstances and preferences.

How is it different from direct index funds?

Currently, most standard index funds have one rule set that dictates what the fund managers should buy and how they rebalance.

The fund manager would then have to stick to this rule, prohibiting them from selling individual stocks within the index in order to keep the ratios intact.

It’s basically a “one size fits all” type of investing.

With Custom Indexing, there is still a rule set, but it’s based on an individual’s own criteria and allows them to buy or sell new stocks as long as it fits within their own pre-defined rule set.

For example, investors might employ criteria such as environmental, social, and governance (ESG), value, growth, or even profitability.

According to US-based O’Shaughnessy Asset Management, custom indexing is still at its infancy stage, and is best served by those with high net worth.

However, as we move into the age of zero-commission trading and fractional shares, this type of investing could become mainstream for smaller investors in the near future.


A direct challenge to passive funds and ETFs

Passive index funds have exploded exponentially since they were first launched in the 1970s.

These are basically mutual funds or ETFs that track the performance of an index such as the Dow Jones (US), Nikkei 225 (Japan), or even the ASX 200 (Australia).

But recent surveys have shown that investors are seeking something other than purely returns, especially now that ESG has taken centre stage.

“The things that made ETFs and mutual funds great are crumbling,” Patrick O’Shaughnessy, CEO of O’Shaughnessy Asset Management, told Barron’s.

“In two years, we’re going to be talking about custom indexing.”

Customisation basically takes diversification a step further, and blurs the line between stock picking and indexing.

For the first time, investors will be able to tailor their portfolio specifically to their own investment objectives.

This means making tweaks to the composition of the portfolio, adding or excluding certain stocks from an index as they fit.

As an example of the flexibility it affords: Tesla was only included in the S&P 500 in December 2020, denying S&P500 index investors a chance to hold the stock prior to December.

But with a customised index fund with an environmental criteria for instance, investors would have been able to include Tesla in their portfolio.

Tax harvesting

Another way custom indexing can be used is for tax harvesting purposes.

For example, an investor in a customised index could sell off losing stocks to realise a capital loss, and to offset against future gains.

They could also sell stocks to take profits on those which have risen significantly — something that’s more difficult with a standard index fund that is more rigid in its composition.

Currently, when your index fund is down significantly for the week because 10 of the biggest stocks in the portfolio have dropped, the advice is usually to do nothing.

With a Custom Index fund, you would be free to sell these 10 stocks, allowing for more tax loss harvesting opportunities.