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Custom ESG Indexing Can Challenge Popularity Of ETFs

Custom ESG indexing – investing directly in the underlying securities of an index – is the future of investing, says Dirk Soehnholz


Shanghai Stock Exchange
Asian equities slipped to their lowest in nearly two years on Tuesday. Photo: Reuters.

 

Charles Schwab, Blackrock, JP Morgan, Morgan Stanley, Goldman Sachs, Vanguard, Morningstar and Franklin Templeton have all recently acquired companies with direct indexing capabilities. 

And faster growth for the already large direct indexing market than for exchange traded funds is predicted.

Direct indexing means investing directly in the underlying securities of an index. For US-based investors, direct indexing can reduce a portion of the relatively high short-term capital gains tax by buying and selling selected index components. 

But direct indexing is very attractive for non-tax reasons, too – for example customised responsible investments – and therefore will not just appeal to US clients.

 

Standardisation: Benefits and problems of ETFs

ETFs can be cheap because they efficiently standardise investments. But standardised products often make too many investment compromises for responsible investors. Custom ESG (direct) indexing can solve that problem. 

The main problem with so-called responsible indices is that most of them try to closely track their corresponding traditional indices. They typically want to include all the major market segments and countries which are represented in the corresponding traditional index. 

Therefore, they often use a so-called best-in-class (BiC) approach. This means that they select the stocks or bonds with the best environmental, social and governance (ESG) ratings by industry.

In addition, some of them exclude controversial market segments such as weapons, tobacco or gambling. But even when they pretend to exclude certain market segments, the fine print often indicates that minor activities in those market segments are still permissible. 

And these ETFs still include ‘good’ ESG-rated companies for many other market segments which may be undesirable for the responsible investor, such as fossil fuels, fast-food, airlines, traditional car manufacturers, cement companies, luxury good suppliers and tourism companies.

With custom ESG indexing, investors can deselect investments according to their own responsibility criteria and/or underweight or overweight certain allocations.

Another reason for not liking ETFs could be that they include the stock of one’s own employer. By being employed at a company one already incurs significant job risk and sometimes compensation includes company stock. It is very reasonable not to additionally want to invest in one’s employer.

 

Thematic direct indexing cases

With thematic direct indexing, investors first use a specific theme to invest in, such as renewable energies. 

They may want to exclude traditional energy providers which are often included in renewables indices. Also, many thematic indices include Microsoft and Tesla. Investors may want to exclude or underweight these allocations in their bespoke thematic indices to mitigate their overall exposure to these stocks.

 

Stock-unpicking instead of active portfolio management

Direct indexing starts with transparent rules-based indices which market performances – and not with often opaque actively created investment portfolios or mutual funds. 

This “stock-unpicking” approach is different from active stock-picking which is often criticised, because it produces underperformance.

It is unclear if such stock-unpicking is good or bad for investment performance. Stock-unpicking clearly reduces diversification but mathematically diversification benefits decrease fast after about 15 stocks. 

And deselecting stocks for social and/or ecological reasons should reduce future social and ecological risks of an investment portfolio.

The case for over- and underweighting of stocks is not very strong, though. Liking or disliking a stock for ecological or social reasons is often easy to argue. But it requires much more know-how to decide on the best weight of companies in a portfolio. 

This argument also applies to the option of adding securities to direct indexing portfolios.

 

Custom ESG self-indexing: Benefits and an example

For direct indexing it is very important to start with a good index. With several million indices available, index selection can be very complex. But simply put, more securities in the same investment universe mean less rigid – eg ESG – selection criteria for the index components. And it is much easier for investors to judge index components if there are only few of them.

Self-indexing differs from active portfolio management since it typically consists of a set of rules which should be transparent so that third parties can replicate the index. 

My own global equity index consists of about 600 stocks out of almost 30,000 stocks with ESG information. With my best-in-universe approach I only select the best ESG-rated investments independently of artificially defined classes. 

I neither use minimum or maximum allocations to industries or countries nor traditional financial stock selection criteria.

Even if investors like best-in-class approaches, they may want a different execution. Best-in-class ESG ETFs typically use aggregated ESG ratings for stock selection and/or weightings. 

So a good corporate governance score can compensate bad social or ecological ratings. With self-indexing one can use high minimum requirements for E, S and G separately, instead.

Also, by owning securities directly and not through an ETF, investors can use their voting rights as they like. They do not have to rely on the often not very responsible voting services of an ETF provider. 

An additional advantage of self-indexing is that there are no index licensing fees, which can be high compared to overall ETF costs.

 

Direct bond and multi-asset direct indexing and risk management

Today, investors can choose from many responsible equity and bond indices but very few for other asset classes such as real estate or infrastructure. This makes responsible direct indexing for REITs and real estate and infrastructure equities especially attractive.

This is also true for thematic indices which rarely include demanding responsibility criteria, if any. Bond direct indexing is more difficult considering the many rather illiquid bond markets and very little fractional bond trading so far.

Asian stock markets

Direct indexers can combine direct equity indices, for example several thematic indices, with responsible bond ETFs, such as 50/50 stock/bond allocations. 

Out-of-sample, such allocations often perform better than pseudo-optimised portfolios which are offered by active investors or robo-advisors. 

However, many investors do not like a 50% allocation to low-yielding bonds. Alternatively, simple and transparent trend following can easily be applied to direct indexing portfolios.

Direct indexing providers could provide simple-to-understand back-testing, risk measurement, scenario analysis and simulation tools. Thus, interested investors can benchmark their individual direct indexes.

 

Implementation as bottleneck for mass-marketing

A few US companies already offer direct indexing services for portfolios starting at $100,000 and with almost free trading and the use of so-called fractional shares, lower hurdles are possible. But even in the US, fractional trading so far is mostly limited to US large caps.

For investors who have sufficient funds to invest, direct indexing is easy to implement through wealth or asset management mandates or bespoke investment funds. 

Since structured products can be created fast and often rather efficiently, they may be especially interesting for direct index implementations.

 

Powerful direct indexing software available

The good news is that powerful and affordable direct indexing software is now available. ALLINDEX, a Swiss fintech founded in 2018 with clients and representatives in Europe, the US and Asia, is one such provider. AllIndex creates indexes for Asia Financial and its parent, Capital Link International. 

The founders and board members have backgrounds at BlackRock, STOXX and the Royal Bank of Scotland, among others. The platform allows instant direct index creation based on market and proprietary data, including ESG information. 

Extensive backtesting capabilities and instant factsheet creation are among the features. The software is provided to clients in a white-labelled, B2B and B2B2C fashion. 

Its sharing features enable in-house collaboration and direct connectivity to end clients. ALLINDEX is a pioneer in bringing direct indexing to end-clients via a simple to use mobile app. 

Based on their AI capabilities, ALLINDEX has a unique selling proposition in the creation of on-the-fly thematic universes. Also, as opposed to its peers, the software can be used for multi-asset direct indexing, including fixed income, digital assets, and commodities.

 

ETF-marketing is the biggest enemy of direct indexing

ETFs are very successfully marketed as especially smart investments with the arguments that they are passive, low cost and heavily diversified. 

Standard direct indexing is similar albeit more expensive, even though typically cheaper than active investing. Custom ESG indexing is also passive in nature and not very expensive, but will typically not be heavily diversified. 

Whereas the additional cost can be seen as low for customisation, diversification arguments may be more difficult to argue. Most ETF-providers have large amounts to invest and therefore need diversification across many large cap securities. 

Product providers and client advisors alike often avoid concentrated portfolios because they would be liable for their selection decisions. More problematically, regulators and so-called investor-advocates also often heavily favour high diversification. 

It will be tough for them to accept that diversification is not as important as they think. 

But the more focused an investment is, the easier it is to understand and the more it can be aligned with the values of a responsible investor. My own experience with concentrated rules-based portfolios for which I almost exclusively use responsibility selection criteria is very positive. I think that custom ESG indexing is the future of investing.

 

  • By Dirk Soehnholz

 

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Dirk Soehnholz

Dirk is the founder and CEO of Soehnholz ESG GmbH, a B2B provider of rules-based model portfolios and mutual funds with a focus on pure ESG and Impact/SDG, an ESG and SDG Advisor to ALLINDEX – a direct indexing provider – an honorary professor of asset management at Leipzig University and a financial blogger.

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