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Stop Waiting, Start Customizing: How Passive Investors Can Make Their Own Rules

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Jennifer Sireklove, CFA

Managing Director, Investment Strategy

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Passive investors may find an index provider’s definition of the market out of step with their own. Find out how custom direct indexing can help them reach a compromise.

Investor confidence that S&P Dow Jones Indices would soon add Tesla Motors (TSLA) to its flagship S&P 500® index grew to such an extent over the summer of 2020 that it was seen as a foregone conclusion. TSLA’s share price rose dramatically over the summer, with many investors trying to arbitrage this pending inclusion. This enthusiasm changed to dismay in early September, when S&P Dow Jones Indices decided not to add TSLA to the S&P 500® during its quarterly rebalance. Investors reacted strongly to this news, sending TSLA shares down 21% the next trading day. 

This example illustrates the critical role of index providers and the level of discretion they may have in adding or removing constituent stocks. Let’s look at why this is just one reason to consider a custom direct indexing strategy instead of remaining dependent on an index provider.

How are stocks selected for index inclusion?

Investor enthusiasm was based in part on TSLA’s passing the final eligibility criteria for S&P 500® inclusion: It was profitable throughout the most recent quarter and trailing four quarters, and the general consensus was that the company had grown too large for the S&P 500® to ignore. Yet these criteria establish only the universe of stocks from which the committee can select new entrants. They don’t guarantee inclusion, which ultimately comes “at the discretion of the Index Committee.” The methodology document goes on to note that the committee reserves “the right to make exceptions when applying the methodology if the need arises.”

TSLA is an especially high-profile example of this discretion, but it certainly isn’t alone. In fact, as of October 9, 93 of the 500 largest constituents of the FTSE Russell 1000 Index were absent from the S&P 500®. All of them have a market cap well larger than the smallest S&P 500® constituents. While not all indexes have that level of discretion, index providers have the ultimate say in how to frame their own rules, which affects the constituents of any index-based portfolio.

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What if investors disagree with index providers?

The heart of passive investing is the idea that investors might be better off trying to be the market instead of trying to beat the market. But this style of investing requires the investor to think about what the market actually is. Most default to a major index, typically from one of the mainstream index providers like S&P Dow Jones, MSCI, or FTSE Russell. These firms offer a variety of market-based portfolios that capture various aspects of the equity markets, built using a transparent and rules-based approach. But investors in an index-based mutual fund or ETF are completely at the mercy of the index provider.

This case highlights the central appeal of customization. Investors might want a certain company in their market exposure and find it odd to have such a large company excluded from the index. They could decide to look for an alternatively defined index that does include their stock of choice—or, if an investor generally agrees with the methodology of their current index but would like to include or exclude some constituent companies, they could switch to a custom direct indexing portfolio. This enables them to own stocks in the index directly instead of owning a share in a fund that holds all the constituent stocks. This approach offers maximum control over the investor’s individual definition of the market. 

A custom direct indexing portfolio offers a rules-based investment experience in which the individual investor sets the rules themselves. Investors who still like S&P’s definition of large-cap US stocks but think TSLA should be included can create their own personal benchmark that adds the stock no matter what the committee decides to do. On the flip side, investors who think TSLA is an overvalued fever dream with no place in their portfolio can create a version of the Russell 1000 that excludes it. 

The bottom line

The intensified emotion surrounding TSLA demonstrates that investors have strong opinions about which names should be included in their market exposures. For clients who want to act on these views, a customized SMA allows a venue to include and exclude names according to their own criteria. They can go even further by adding factor tilts, ESG guidelines, and tax management to their portfolios—all ways to take customized investing beyond direct indexing.  

References to specific securities and their issuers are for illustrative purposes only and are not intended to be and should not be interpreted as a recommendation to purchase or sell such securities. It should not be assumed that any of the securities referenced will be profitable in the future or will equal their past performance. All investments are subject to risks, including the risk of loss.

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.