By Maria Elisa Giraldo, Manager, Account Based Marketing and Michael Demilio, Senior Manager, Marketing, Investment & Wealth Solutions
Direct indexing has been generating a buzz in the wealth management marketplace, as more investors are prioritizing customization. As with any index strategy, direct indexing implementation starts with selecting an index—and the success of the strategy largely depends on the quality of the index.
To assess the quality of an index, it’s important to carefully examine what comprises it. As shown, we’ve identified the three key index components that advisors should evaluate when selecting a starting index for a direct indexing solution.
Robust methodology underpins the highest quality indexes
An index is only useful to the extent that it accurately reflects the asset class it’s designed to represent. To best achieve client objectives in a direct indexing solution, advisors should seek an index with rules-based, transparent, and easy to understand construction methodology—allowing for a reliable and consistent representation of an asset class.
While indexes from different index providers might appear to represent the same asset class, differing methodologies can result in material differences in index composition—and in index performance. For example, at FTSE Russell, we use a rigorous and transparent methodology to construct our indexes, where companies are required to meet a robust set of criteria for inclusion. And while these criteria are designed to screen companies for eligibility based on characteristics such as minimum voting rights, investability, and liquidity, they don’t include profitability requirements.
By contrast, S&P index methodology requires four consecutive quarters of profitability for index inclusion. This difference in methodology has meaningfully impacted index performance. As shown, we added some companies to the Russell 3000 Index shortly after their IPOs—and these names grew significantly in the intervening period between inclusion in the Russell indexes and inclusion in the S&P indexes.
Strong governance ensures index data integrity
The methodology of an index is only as good as the index provider’s governance policies. A strong and comprehensive governance policy can give an advisor confidence that the methodology will remain consistent and won’t result in unexpected changes in index composition.
To ensure that FTSE Russell indices are constructed, maintained, and operated to the highest standards, FTSE Russell employs a robust governance framework to approve new indexes and changes to existing index methodology. The framework combines specialist decision-making bodies with an oversight committee and a set of independent external advisory committees supports them.
Support and resources beyond the index
Index providers can work with advisors and wealth managers to create a comprehensive and sound universe of securities that can form the basis for a direct indexing solution. However, the most prominent index providers will offer more than just a starting universe for a direct indexing strategy. This underscores the importance of evaluating an index provider holistically and assessing available resources and support beyond the index.
For example, advisors will need relevant material for client communications. Index providers can offer background and education on the index, the baseline for diversification, and help manage and communicate changes like index rotation and the impact of corporate actions. Additional index provider resources can include research, thought leadership, and product specialists.
The index plays a key role in any direct indexing solution
Over the past two decades, index allocations have become a portfolio staple in the wealth management marketplace. More recently, direct indexing has risen to prominence in the index investing conversation. As a growing number of wealth management firms and advisors implement direct indexing solutions, it’s essential they don’t underestimate the importance of starting index selection—and know what comprises the highest quality indexes.
Please see our recent paper for more information and subscribe to the FTSE Russell blog.
© 2023 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE Canada”), (4) FTSE Fixed Income Europe Limited (“FTSE FI Europe”), (5) FTSE Fixed Income LLC (“FTSE FI”), (6) The Yield Book Inc (“YB”) and (7) Beyond Ratings S.A.S. (“BR”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB and BR. “FTSE®”, “Russell®”, “FTSE Russell®”, “FTSE4Good®”, “ICB®”, “The Yield Book®”, “Beyond Ratings®” and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.
All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of FTSE Russell products, including but not limited to indexes, data and analytics, or the fitness or suitability of the FTSE Russell products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell products is provided for information purposes only and is not a reliable indicator of future performance.
No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this document should be taken as constituting financial or investment advice. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any representation regarding the advisability of investing in any asset or whether such investment creates any legal or compliance risks for the investor. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset nor confirmation that any particular investor may lawfully buy, sell or hold the asset or an index containing the asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back-tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.
This document may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB, BR and/or their respective licensors.