Learn how responsible investors can use direct indexing to precisely align their investments with their values.
As investors increasingly put their money where their values are, the financial industry has responded by rolling out a number of responsible-investing strategies. However, due to the challenges in offering a commingled vehicle, the definition of responsible for these products is meant to appeal to as wide an audience as possible. Because of this one-size-fits-all approach, it’s rare for these products to perfectly reflect the views of any single investor, potentially forcing investors to invest contrary to some of their core beliefs.
Thankfully there’s a solution: custom direct indexing, which allows responsible investors to construct portfolios that express their unique values without compromising on their investing mandates.
Why should responsible investors use direct indexing?
Direct indexing is similar to exchange-traded funds (ETFs) and mutual funds in that it provides broad market exposure. But the stocks or bonds held in these collective vehicles are fixed, putting investors at the mercy of a manager or index provider’s view of what makes a company good or bad from an ESG perspective. By contrast, custom direct indexing allows investors to choose which securities to own, ensuring their holdings align as precisely as possible with their particular ESG preferences.
This structural difference means direct indexing provides a level of flexibility not found in off-the-shelf passive solutions. It gives investors full control of their underlying securities, meaning they determine which companies to hold and at what weights. At the same time, risk controls are put in place to ensure the desired market exposure is largely maintained, despite any increased emphasis on good companies in the portfolio.
Tailor client portfolios to their values
With direct indexing, investors can express their individual ESG views and gain the market exposure they’re seeking through portfolio construction, active ownership, or a combination of the two.
Portfolio construction allows investors to customize their passive exposure, enabling them to own good companies that reflect their ESG principles while excluding bad companies that conflict with those principles. This can be accomplished with screens that only include companies with the best ESG track records or characteristics as the investor defines them.
Customization can also be achieved through a quantitative integration process, which overweights companies with higher ESG scores while underweighting those with lower scores.
Source: Parametric. For illustrative purposes only.
With active ownership, investors choose to own shares of bad companies so they can advocate for change at the corporate level. Through proxy voting, direct engagement with the company, and shareholder resolutions, investors can use their ownership stake to urge a company to make ESG-related improvements.
Source: Parametric. For illustrative purposes only.
At the same time, investors shouldn’t lose sight of their preferred market exposure. Custom direct indexing portfolios are built to remain as close as possible to the risk characteristics of an initially desired exposure, all while taking particular ESG views into consideration. This means the investor can build a custom direct indexing portfolio using any market exposure of their choice, not just the ones available in a ready-to-go fund. This allows investors to build portfolios that reflect not only their views on ESG but also their geographic, sector, or factor preferences. Such a plan offers the benefits of keeping similar risk characteristics to the investor’s target strategy while incorporating their principles into their investments.
The bottom line
Custom direct indexing portfolios provide for a range of customization and control, providing greater freedom to express socially responsible views. The structure of a direct indexing portfolio means an investor can take advantage of flexibility that isn't possible in other passive solutions, like ETFs or mutual funds. With its ability to customize a portfolio as precisely as possible, direct indexing opens the door for investors who couldn’t find what they were seeking from mass-market solutions.
