Rethinking Portfolios: A Visual Guide to Direct Indexing

A Visual Guide to Direct Indexing

Like many other industries, creating custom experiences has become the standard—and investing is no exception.

Direct indexing allows investors to create a personalized index that offers direct ownership of relevant investments. Given the diverse set of client needs, a direct index offers one avenue to meet each investor’s unique objectives. Reducing taxes and boosting ESG metrics in a portfolio are among just a few.

In this graphic from MSCI, we show how direct investing works, and the opportunities it offers.

Direct Indexing, Explained

To start, direct indexes are one way for investors to create a custom index in separately managed accounts. In that account, an investment firm will oversee a portfolio of assets.

Advisors can help clients decide the number of holdings, ESG screens, or sector inclusions that more closely align with their needs.

The benefit of using this approach is that investors have direct ownership of these holdings, which allows for certain tax advantages. This is in contrast to mutual funds, which are pools of assets owned by a number of investors. Through direct indexing, for instance, an investor could apply tax-loss harvesting by selling securities at a loss to reduce their capital gains tax.

At the same time, direct indexes can use analytics and risk modeling to identify the drivers of risk and return. In short, direct indexing gives investors access to tools that power portfolio construction and performance measurement.

How to Leverage Direct Indexing

Let’s say an investor wants to build an index with the following features:

• Improved ESG score
• Lowered risk
• Increased global exposure
• Reduced tax burden

Using direct indexing, they can choose which objectives align most closely to their needs. For example, they may choose from the following investment exposures:

Consider the investor who’s specifically looking to reduce the carbon exposure of their portfolio by 30%.

Since the investor wants to improve their ESG score, they could consider a Low Carbon index which has a mandate that may align with these goals. Let’s say, they also wanted to invest in companies that have a greater focus on the ‘G’, or governance side of environmental, social, and governance (ESG) investing. In this case, they may choose to blend their exposure with a Women’s Leadership index.

Suppose the investor is risk averse and wanted a portfolio with lower volatility. Through utilizing sophisticated risk models and analytics, the index could integrate a Minimum Volatility index to help manage their desired risk.

The Direct Indexing Toolkit

Direct indexing provides a set of tools for investors to use to their advantage. Primarily, these could consist of:

• ESG metrics: Carbon Portfolio Analytics, measuring alignment to the UN Sustainable Development Goals, insights on ESG risks and opportunities
• Risk optimization: Efficient frontiers, mean-variance optimization, max Sharpe ratio or information ratio
• Tax optimization: Tax aware portfolio construction, tax-loss harvesting, maximizing post-tax returns

Through an efficient frontier, an investor can identify investments that have the highest returns for an identified level of risk. Mean-variance optimization is another type of investment tool that helps investors achieve the optimal level of risk and return, by dispersing the risk across their portfolio.

With an expansive set of index products, 24-hour service, and dedicated research team, MSCI works hand-in-hand with investors to build their desired portfolios.