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Move over direct indexing: Custom indexing is the next big thing in investing

The gap between innovations in investing has progressively shortened over the past 100 years. Mutual funds had a 70-year head start before ETFs arrived on the scene. ETFs enjoyed a three-decade stretch before direct indexing knocked on its door. And in less than five years, direct indexing has ceded its role as a “newcomer” to custom indexing. 

Custom indexing, which uses technology to lower the barriers to true personalization, is set to become the next big thing in investing. Such claims may raise questions from advisors, namely, how does it work and what are the benefits?

Here’s everything advisors need to know about the new technology.

What is custom indexing?

Custom indexing allows advisors to build custom portfolios using individual securities rather than ETFs or mutual funds. Most aspects of a portfolio can be customized to a clients’ unique goals and needs, from the initial asset allocation choices to the different values-based screens advisors apply. This differs from previous solutions in that financial advisors and their clients—not asset managers—now make decisions about asset selection and portfolio optimization. 

Now with a blank slate, advisors can build virtually any portfolio a client wants. Suppose a client cares about environmental causes, they can actively avoid companies that downplay sustainability or overweight companies where green practices take precedence. Or perhaps a client is interested in lowering their tax liabilities. With stock-level tax-loss harvesting and improved capital gains management, advisors have more options to make this happen. The possibilities are endless. 

All of this may sound like old-fashioned stock picking, but custom indexing is more like traditional index investing, and not just in name. Advisors use software and algorithms to set rules for the customization and optimization of a client’s portfolio, and from that point on, the custom indexing technology automates the ongoing management of the portfolio.  

How does it differ from direct indexing?

On the surface, custom and direct indexing strategies share more similarities than differences. Both approaches let advisors build portfolios of individual securities in separately managed accounts. Both approaches let advisors invest in things that clients care about: ESG, values, or tax management. And both approaches let advisors reduce unnecessary risks clients face from concentrated positions. 

But dig a little deeper, and the differences become apparent. At its core, direct indexing tries to replicate the performance of an index by owning individual securities rather than ETFs or mutual funds. Advisors can tweak clients’ holdings only so much before they deviate too far from the benchmark. By contrast, critical decisions in a custom indexing platform rest on the shoulders of the advisor and their clients. Advisors, not the index provider, establish controls for asset allocation, asset selection, and portfolio optimization (e.g., rebalancing, tax management, values-based investing).

And since custom indexing is anchored in technology, the quality of tools and software used to construct portfolios become much more valuable than in direct indexing. 

What are the benefits of custom indexing?

Custom indexing builds on the success of previous investment management products, allowing clients to reap the same benefits as mutual funds, ETFs, and direct indexing, plus more. 


It’s personalization in the truest sense of the word. When building a portfolio, advisors can create and employ custom strategies that do what clients want—not what fund managers can offer. This might be as simple as adding large-cap value exposure to a portfolio, or it can be more complex, such as creating a new factor to invest in companies with strong female leadership. 


For a long time, the narrative around ESG focused on two major themes: greenwashing and lower potential returns. With custom indexing, that changes. No longer do clients have to settle for ESG ETFs that look like glorified tech funds. The 84% of investors interested in ESG can now pick and choose investments that align with their values. Maybe that means excluding fossil fuel producers. Or maybe a client rules out companies who still perform animal testing in their products. 

Tax management

Nearly 87% of affluent investors believe they will achieve their goals with a tax-efficient financial plan. Custom indexing helps turn this belief into reality. By holding individual securities, advisors can harvest losses and gains more efficiently than in the past. They can also set capital gains thresholds, so clients never pay more than they intended to. 


The old saying of “don’t put all your eggs in one basket” takes on a new meaning when advisors use custom indexing. It’s no longer about diversifying a portfolio across what an advisor can see but also what they can’t. Their client may hold a concentrated position in a single stock separate from their professionally managed portfolio. If that stock tumbles, it puts their goals in jeopardy. It doesn’t matter how well an advisor diversified their professionally-managed portfolio. The good news is that advisors can now remove individual holdings or similar names, so their clients are truly diversified across their entire holdings. 

Custom indexing is the next logical step in the evolution of index investing. Advisors who want to give clients a truly customized portfolio should take note.

November 3, 2021