Custom indexing: a powerful way to express unique investment ideas
The application of custom indices is expanding beyond research and analysis, allowing users to address specific investment goals
Published
April 2024
Senior Director, Head of Product Development, ICE Data Indices
Head of ICE Data Indices
In the nearly 140 years since Charles Dow published the first stock market index, indexing has changed investing.
From Jack Bogle’s index investment trusts to the soaring growth of exchange traded funds (ETFs), market indices have become increasingly sophisticated and embedded in the foundations of today’s investment markets.
But the seemingly unstoppable rise of index investing has raised new challenges — for all the variety, off-the-shelf investment solutions cannot account for the specific needs of everyone.
Now, a wave of change is sweeping the investment landscape, offering granular customization of indices.
Custom indexing addresses the shortcomings of passive investing by enabling more detailed customization according to the needs of individual clients.
So, what is custom indexing, and how does it work?
In terms of methodology, a custom index can deliver any objective that can be expressed as rules in an algorithm. At ICE, we view a “custom” index as one that is calculated on behalf of a specific client.
In its infancy, custom indexing aimed simply to create a fair performance comparison — setting a benchmark that allowed clients to see the relative performance of a portfolio.
This is still an important feature. Portfolio managers often agree to investment guidelines with their clients: limits on concentration, exclusions of certain sectors, specific terms on allowed securities. All these factors can be implemented in a custom benchmark, allowing a fair basis for comparison.
Custom indices are also useful for research, allowing analysis of the historical performance of different assets and their correlations, and for portfolio managers to understand the drivers of risk and reward. This is fundamental to the principles of portfolio theory.
But custom indices have moved beyond these traditional applications.
The rise of customization
Custom indices can now also address specific investment goals in a portfolio, such as the inclusion of thematic and megatrend exposures or environmental, social and governance (ESG) factors.
For ESG investors, custom indexing offers a powerful alternative to active security selection. An ESG portfolio is fundamentally an agreement between a portfolio manager and a client to include or exclude certain investments — perhaps by taking an underweight position in fossil fuels or an overweight in companies exposed to the clean energy transition.
ESG investing is complicated by the fact there is no consensus on what an ESG portfolio should look like. There are multiple datasets, competing opinions and no single definition of what assets an ESG approach should include. Asset owners also have different sensitivities and vastly different timeframes for ESG.
In these circumstances, an index that implements a custom-made view of an ESG portfolio can be of benefit.
Thematic investing is another area where customization comes into play. Unlike traditional sector or industry investing, thematic investing often straddles sectors in aiming to capture global megatrends such as artificial intelligence, robotics, the metaverse and autonomous driving. These are not clearly defined investment themes, and thus can benefit from increased customization.
A rules-based approach
A custom index is managed through a transparent, rules-based method that selects and weights constituents. For a long time, investing was the process of selecting individual stocks. With the advent of mutual funds, investors could pool their funds and hire an active manager to do the stock picking. Index funds and today's passively managed ETFs, which track broad-based market indices or asset classes, were a natural evolution.
Now, customizing indices allows for strategies that were previously only available from active managers to be available to passive funds.
ICE has already delivered many different thematic indices, including several electric vehicles and autonomous driving indices, each with significantly different views on the types of companies that should be included and how the index should be compiled.
When it comes to custom indexing, we believe clients should control the process. That’s why ICE’s approach provides clients with a high level of power and flexibility, with an end-to-end system from ideation to index. Unlike existing tools that are geared towards portfolio back-testing, our Custom Index Tool is designed to create indices, with nuanced control over rebalancing, universe selection, weighting, the treatment of corporate actions and filters. This web-based tool allows users to prototype and share simple or complex custom indices, perform historical research and analyze data. And as the universe of indices continues to evolve, the concept of customization will only become more powerful.