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Custom Indexing

Custom Indexing

Posted February 28, 2024 at 11:00 am
Andrew Wilkinson
Interactive Brokers

Guest: Sanjoy Ghosh, CIO Interactive Advisors

For investors, tracking an index has allowed them to target exposure within specific sectors and industries. And the advent of ETF or exchange traded fund investing has made this readily accessible to investors. But, imagine if you could invest in the what you think are the best stocks within an index or exclude a sector you felt would fare badly under current economic conditions. That’s what Custom Indexing (or Direct Indexing) is all about and common practice for Advisors.

Summary

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

Welcome to this episode of the IBKR Podcast. My name is Andrew Wilkinson. Today, we’re going to be talking about custom indexing for investors. Tracking an index has allowed them to target exposure within specific sectors and industries. And the advent of ETF or Exchange traded fund investing has made this readily accessible to investors. But imagine if you could invest in what you thought were the best stocks within an index and even exclude a sector you felt might fare badly under current economic conditions. That’s what custom indexing or direct indexing is all about, and common practice for advisers. I’m joined here today on this episode by Sanjoy Ghosh, CIO of Interactive Advisors welcome, Sanjoy. How are you?

Sanjoy Ghosh

Oh, good. Thanks. Thanks for having me.

Andrew Wilkinson

Sanjoy, you are primarily responsible for developing a piece of software that enables advisors on the Interactive Brokers platform to invest using custom indexing. Could you just describe that a little bit please?

Sanjoy Ghosh

Oh, sure. So, what is direct indexing or custom indexing? Let me illustrate with an example. So, let’s take a widely popular ETF, something like the SPY ETF, which tracks the S&P 500 that is actually comprised of 500 or so stocks, each with its own weightings. Now using custom indexing, advisors can sort of copy that list of SPYs individual holdings and weightings. Save the list as a customized index and then deploy it as a model that can be tailored to their client’s needs. So rather than buying into the ETF, what you actually do is you actually own the 500 stocks that make up the S&P 500. You own it in your own account. And one of the big advantages of this framework over buying the ETF directly is that you can harvest losses. If there are losses and individual stocks within the benchmark ETF, so to speak, you can harvest losses for those stocks. And why would you do that? It’s to potentially reduce your tax bill. So that’s direct indexing. Now we kind of use the words direct indexing and custom indexing interchangeably, but custom indexing is direct indexing plus your own individual preferences. So custom index is where your individual preferences come into play, and this is where you actually start deviating from the underlying benchmark ETF. So, you may not hold exactly the same stocks that the underlying ETF does. You may choose to exclude some; you may choose to overweight some, and this is where you’re sort of drifting away from holding the passive benchmark, applying your own customizations. And the composition of the final portfolio will reflect your own preferences and conviction.

Andrew Wilkinson

You talk about customization. What can an advisor customize?  For example, is it possible to really exclude companies with negative earnings?

Sanjoy Ghosh

Oh yes, it gives you tremendous flexibility to customize. The way we’ve developed this tool, you can customize in a lot of different directions. You can exclude single stock, you can exclude the list of stocks, example of which would be that you exclude all companies with pure ESP ratings. That happens to be something that you care about, and you won’t exclude companies that violate that. You can even exclude companies that satisfy fundamental criteria. So, you asked about negative earnings. Sure, it’s possible to exclude companies with negative earnings. Beyond that, you can also overweight or underweight stocks within certain sectors. For example, you might be very bullish about healthcare stocks. You might want to overweight those companies, and you might be very bearish about oil companies, and you want to underweight those companies relative to the underlying benchmark. So, the tool gives you tremendous flexibility on how to customize.

Andrew Wilkinson

So, it sounds a little bit like the S&P 500 according to me. OK, so can I remove those customizations whenever I want?

Sanjoy Ghosh

Absolutely. So, you’ve chosen those customizations. You might find that they’re not, they don’t apply to you at this point in time, and you want to change them. You’re in complete control on what the portfolio looks like and you can add customizations; you can remove customizations; you can change customizations. Just keep one thing in mind, the more you customize, the more you’re sort of becoming active in the sense that you’re becoming more and more different from your passive benchmark ETF. So that’s one important caveat.

Andrew Wilkinson

Is it still true that there are high expense ratios for some ETFs, and should those high expense ratios have dissipated to becoming free nowadays?

Sanjoy Ghosh

ETFs, they’ve become widely popular in the last few decades and with good reason. You know they’re great products, expense ratios with popularity with you know, increasing competition.  Traditional expense ratios have come down in general, but then inexpensive is a relative term. There are many ETF that still continue to charge high fees. Charging 0.5% of investment amount as an expense fee. It’s not uncommon. There are several ETFs that you know charge high fees. But with direct indexing, with this new innovation, there is finally a way to get performance similar to the ETF, but without necessarily paying the high fees. So, you get the advantage of actually holding the underlying constituents, not paying the fees or the expense ratio to the ETF provider and also having the added advantage of being able to harvest losses to potentially reduce your year-end tax bill. And after all, after tax returns, this is what everyone does care about.

Andrew Wilkinson

I wanted to pick up on something you said earlier about harvesting losses. So, let’s say for example, an ETF is up for the year, but some of the constituent parts are down. Tell me about harvesting losses on specific stocks.

Sanjoy Ghosh

Oh yeah, this is one of the biggest advantages of, you know, directing custom indices. So going back to the SPY example, let’s say that the SPY is up for the year. That doesn’t mean that all 500 of its constituents are up for the year. It’s uh, it’s possible that you know, some of them have done very well. Some of them have done very poorly and some of them actually have unrealized losses that can be harvested. Well in this scenario, what direct indexing and custom indexing does offer the client is the ability to harvest losses in the companies which have had losses and potentially reduce the tax bill. Now, of course, the more you sort of do that, the more you’re sort of drifting away from the underlying benchmark. Your composition of the custom index is becoming different from the underlying benchmark. So that’s one caveat to sort of keep in mind. But then again, the fact is that having this custom index framework allows you to harvest losses even when the overall benchmark or index is up for the year?

Andrew Wilkinson

Now, I’m aware that ETF holdings change overtime.  With custom indexing, will I be getting stale holdings?

Sanjoy Ghosh

So, in our implementation, custom indexing also uses fresh data, so we do recognize that benchmark ETF holdings data and weights they change, they’re updated, and the way in which we’ve designed our custom index is that this change will get reflected in your custom index, the benchmark weights that are showcased in your custom index. They will change to reflect the changes in the underlying benchmark ETF.

Andrew Wilkinson

What about, say, small cap exchange traded funds do you offer custom indexing for those products?

Sanjoy Ghosh

Actually, we do. Interactive Brokers offers custom indexing for a very wide range of ETFs. I’ve been using SPY as an example, you know, but it’s not just SPY, But the advisor can direct index and custom index.  And even though you know a lot of our competitors just offer a handful of ETFs that can be replicated this way, we offer ETFs that span, you know mid cap, small cap, individual sectors. You know we’ve got a very wide offering of ETFs that can be replicated using this framework.

Andrew Wilkinson

And what about the audience here? Is custom index only open to big investors, given dozens or hundreds of underlying stocks don’t I need a lot of money to invest?

Sanjoy Ghosh

Great question. So, this is one of the biggest breakthroughs of custom and direct indexing. Historically, it’s not that direct indexing is new, it’s been in the market for a while. So, but it was traditionally just offered to very large clients in their separately managed accounts. Now you can get access to it with very low minimums, so that opens up the audience, you know, to clients who want to sort of get their feet wet, try out this product but with low minimums. This is possible because technological breakthroughs have allowed things like tax loss harvesting that can be scaled up. It’s possible because IBKR now allows trading in fractional shares. This allows you to buy all the 500 stocks in the S&P because you can own fractions of those shares. And because it offers a very low commission structure where it’s feasible now to invest in hundreds of stocks with a very low minimum. So, all of these have come together and sort of resulted in this breakthrough of making custom indexing available with very low minimums.

Andrew Wilkinson

Now let’s talk about performance a little bit here. This is now the S&P 500 index. According to me, will custom index performance be different from the underlying ETF? And I guess more specifically, can it be lower than the ETF’s performance and why would that be?

Sanjoy Ghosh

Absolutely it will be different from the underlying ETF and, by different, it means that it can be lower, it can be higher. So that’s one risk that you do need to keep in mind and the risk is that as you start personalizing the direct index as you start customizing as you start adding more and more rules like excluding certain companies or weighting certain sectors, excluding certain lists of companies, the portfolio composition begins to drift away from the benchmark ETF composition.

So, the more customizations you have, the more the drift. Because the more customizations mean your portfolio is becoming more and more active, so to speak, and the active it means that you’re drifting away from the passive benchmark. So, when you make stock replacements and this, this is not just for customizations. This is also happening when you choose to harvest losses, you harvest losses, and you replace one company with another company. So, the portfolio composition begins to drift even further. So, the end result is that your portfolio starts becoming more and more different from the underlying benchmark and consequently the performance of the custom index will be different from that of the underlying ETFs. The less customization you do, the more similar it will be, the more customizations you do when you sort of affect the performance. So, it could be higher or lower because the holdings and the portfolio weights will be different.

Andrew Wilkinson

How does Interactive Brokers make money by offering custom indexing?

Sanjoy Ghosh

So, we feel that custom indexing represents the next generation of investing. It has so many of these benefits over 8 years. As I mentioned historically, it was offered only to very large clients and their SMA’s. Tax loss harvesting was tedious. It’s very time consuming, but all of that has changed with fractional trading, with achievements, with advancements in technology… tax loss harvesting is now scalable across hundreds of clients. This is a sort of new, innovative product, and IBKR has always been committed to bringing low-cost cutting-edge products and making them available to financial advisors who are looking to sort of use IB technology to offer exciting products to their clients, and that’s what this offering is all about. It’s to offer the best existing products through financial advisors and make our platform even more attractive to them. So that’s the sort of end goal of this product.

Andrew Wilkinson

Sanjoy Ghosh, CIO at Interactive Advisors. Thank you very much for coming along to the studio today to talk to me. It’s a great podcast. Thank you.

Sanjoy Ghosh

My pleasure. Thank you. Thanks for that.

Andrew Wilkinson

And don’t forget to look out for additional podcasts at IBKR podcasts and leave us a review.

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About IBKR’s Custom Indexing

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