Abstract

Institutional asset owners increasingly seek to customize index-linked strategies in order to take their ESG and climate preferences into consideration. This trend away from cap-weighted benchmarks does, however, bring forth challenges for asset owners in fulfilling their fiduciary duties. To address these issues, a new self-indexing approach can provide investors with the tools to fully control the index design process and independently monitor the direct and indirect impacts of customization decisions. A 2023 EDHEC survey of institutional asset owners in North America and Europe reveals that less than half of respondents have the capacity to fully analyze their risk exposures, but more than 90% anticipate the further development of digitalized customization capabilities in the institutional passive investment industry. These findings highlight the significant potential for the use of self-indexing as a solution to help institutional asset owners fulfill their fiduciary responsibilities.

Key takeaways

• Institutional investors who wish to implement ESG preferences and are looking for holistic risk analysis capabilities can currently follow a self-indexing approach and independently design customized indices to meet their needs. They can build on available direct indexing technology, in particular, the digitalized portfolio analysis and construction functionalities on offer.
• US large cap equity data reveals the presence of tradeoffs between finance and ESG objectives. A 2023 EDHEC survey revealed that the vast majority of survey respondents (68%) consider that they could establish a priority between their financial and ESG objectives, opening the way to transparent and systematic portfolio construction methodologies.
• Most respondents (over 90%) believe that the institutional passive investment industry is heading towards further customization capabilities and that digital customization services inspired by direct indexing can facilitate this evolution.

Introduction: The Long Road Towards Full Customization

The history of equity indexing can be described as a long road from consensus-based investing towards full customization. This journey and the emergence of a customization-based paradigm naturally raise the question of the role and status of the index provider. We start by presenting a brief account of the history of passive equity investing and highlighting its main phases.

In the beginning was the broad market capitalization-weighted (CW) index. At the time, the objective was market representation, supported by the idea that there was only one possible representation, largely due to the influence of seminal academic works of Markowitz (1952), Tobin (1958), Sharpe (1964) and Lintner (1965). The theory offered a framework where all investors would hold a portion of the same market portfolio, comprised of all available risky assets weighted by their value. This led to the development of investment strategies based on a CW index (used as a proxy for the market portfolio) and ultimately to the creation of public investment vehicles such as the first index mutual fund launched by Vanguard (see Malkiel (2022)). The CW index provider was therefore the representative and the advocate of the market consensus. In this context, the index provider’s intellectual property consisted of a methodology whose value resided in the consultation with investors and the transparency associated with the process. Major providers therefore derived their strength from their large client base.

The decade that followed the financial crisis saw the emergence of non-CW smart beta indices, as the efficiency of CW indices began to be questioned. Indeed, a portfolio of stocks weighted by capitalization is not necessarily a good proxy for the true market portfolio (which should in principle go beyond equities and include all assets in the universe, including non-tradable ones like human capital). Additionally, the true market portfolio is only optimal under unrealistic assumptions and may potentially be complemented depending on an investor’s idiosyncratic aversion to changes in non-traded state variables such as labor income. This shift led academia and the industry to think about better (smart) indices. Unlike their predecessors, these indices no longer aimed to solely represent a market consensus but were instead the fruit of genuine research specific to the index provider. This new focus gave rise to new actors in the indexing world, showcasing their research either as asset managers or investment advisors (e.g., RAFI, Tobam, Robeco) or as representatives of the academic world (e.g., Scientific Beta), alongside traditional players with research capabilities (e.g., MSCI, Qontigo). Smart beta indices bear a reputational and fiduciary risk which institutional investors wish to minimize by controlling the distance relative to CW indices and by selecting methodologies backed by research grounded in academic consensus, as is the case for factor investing, or by original research validated by publication in respectable journals. For example, most of the highly successful smart beta indices in the US have been the subject of research in two industry-recognized journals (the Financial Analysts Journal and the Journal of Portfolio Management). It is worth noting that the reflection of investor preferences on the construction of a smart beta index is generally limited. For example, in the case of factor investing, which has represented a large share of the smart beta segment in the last 10 years, the choice offered to the investor is often limited to a factor menu or to sector control deviation options; the investor indeed relies on the index provider’s proprietary research when it comes to the portfolio construction methodology and to the definitions and proxies of the selected factors. In this context and due to their focus on risk mitigation, simulated track record of the index and an analysis of the tracking error risk. Some observers have considered that the promise of outperformance made by index providers based on their research has de facto granted them a role that is not very different from that of an investment advisor, and as such, has assigned index providers a fiduciary responsibility to the extent their index methodology could lead to discretionary decisions, or at least decisions resulting from rules that were not known to and approved by the investor.

Finally, the last decade saw the arrival of non-CW indices integrating environment, social or governance (ESG) criteria. Even though these ESG indices are often derived from broad CW indices, their composition and/or weighting schemes use non-financial stock-level characteristics and may sometimes lead to fairly strong deviations from broad indices. This may be due to sector allocation, since some sectors are often strongly under-represented (e.g., oil & gas and more generally energy in climate indices), or to stock-level allocation, since some stocks may be under-weighted or excluded based on ESG criteria. For example, recent research carried out by EDHEC Business School as part of the Scientific Portfolio project has shown that complying with a “do no harm” (DNH) exclusion policy with respect to each of the 17 Sustainable Development Goals (defined by the United Nations) leads to an exclusion of almost 40% of the stocks in the world developed markets universe. Given the absence of either an academic or an industry-wide consensus with respect to the construction of ESG portfolios, the design of an ESG benchmark (and more generally the field of ESG investing) is more representative of an institutional investor’s preferences and notably the objectives defined by its governing body or managing board, than the result of the index provider’s internal research. Consequently, the value added by the main ESG index providers is ultimately more about access to new data than the imposition of a particular portfolio construction method. More recently in Europe, the newly adopted regulations (e.g., the Sustainable Financial Disclosure Regulation, or the Paris-Aligned Benchmarks) detailing the obligations pertaining to this data (e.g., disclosure and usage requirements) have also structured ESG, and particularly climate, index offerings.

Clearly, the predominance of investor preferences in index design has had considerable consequences on index offerings. These consequences not only include the development of strong customization capabilities, offered by players such as Solactive, but also the desire of major actors such as Qontigo or MSCI to offer client-driven indices that both reflect investor preferences and rely on proprietary index construction technical capabilities (e.g., powered by risk models such as Axioma or Barra). However, the alleged full customization of indices is ultimately a commercial offering from index providers who understandably aim to showcase the quality of their product. This can manifest through various means, whether it be via the selection of the most favorable metrics supporting the affirmed objectives of the index, the choice of the backtesting period, or more generally, the adoption of a framework to perform an index risk analysis. Therefore, although the investor indeed expresses customization choices, the implementation of these choices remains the responsibility of the index provider.

This phenomenon has been particularly pronounced recently, as many ESG index providers showcased the outperformance of ESG strategies. For example, some indicated that ESG strategies may have protected investors from the Covid crisis while omitting to mention that this performance resulted from implicit choices of factor exposures (overweighting the profitability factor which is typical of defensive strategies, and underweighting the value factor which is generally considered cyclical) and sectors (underweighting the energy sector and overweighting technology stocks). These exposure choices then had highly negative consequences on 2022 performance due to the value recovery and the energy crisis. See for instance Bruno, Esakia and Goltz (2022), who report that while the returns of ESG strategies look attractive between 2008 and 2020, 75% of their observed outperformance may be explained by quality factors (that are typically proxied by profitability measures).

It is in this context, characterized not only by the predominance of full customization but also by the necessity for investors to take ownership of their customization choices (and of their consequences), that the concept of self-indexing, already popular amongst retail and high net worth individual investors through direct indexing offerings, is beginning to emerge in institutional investment management.

The objective of this article is twofold, which is reflected in the organization of the remaining sections. First, in section 1, we highlight the commonalities and the differences between self-indexing and direct indexing, as the latter may intuitively be considered as a template and a source of inspiration for a digitalized index customization institutional offering. Then, in sections 2 and 3, we cover institutional self-indexing from two complementary perspectives, i) by reporting the key findings of our dedicated survey of institutional investors on the topic (full results are reported in the annex) and ii) by describing and illustrating the benefits of self-indexing for investors seeking to fulfill fiduciary responsibilities in the context of passive investment management.

Authors

Benjamin Herzog
Chief Executive Officer,
Scientific Portfolio

Shahyar Safaee
Deputy CEO and Business Development Director,
Scientific Portfolio

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