The demand for custom indexing

Quant technologies provider SigTech says because the current equity bull market has coincided with an exponential rise of indexing, a significant part of inflows into funds and ETFs over the last decade have been allocated to market capitalisation-weighted (MCAP) indices. This has created, often unintentionally, risk issues for many investors, such as over-exposure to regions and sectors – in particular the US, technology, communications services and consumer sectors.

In a new paper entitled ‘Is the bull market about to end and is now the right time to diversify your equity portfolio?’ SigTech notes that institutional investors are becoming increasingly concerned about the end of the equity bull run. Their concern is fuelling the rise of custom indexing, which enables investors to define their investable universe, tailor investment strategies to their specific needs, and gain exposure to various risk factors that are optimal for them.

Daniel Leveau, who heads SigTech’s strategic initiatives for institutional investors, said: “The US stock market is currently trading at valuation levels only exceeded during the TMT bubble of the 90s, and many MCAP indices’ largest constituents are trading at valuation ratios significantly above their long-term averages. Investors should ask themselves how sustainable these are.”

“MCAP indices are per construction tilted to growth, large size and – during a bull market – momentum risk factors, and strong inflows into these translates into higher demand and rising prices for stocks exhibiting a strong tilt to these risk factors. Examples of the ensuing high concentration risk are the US stock market’s historically high weighting in the MSCI World index of almost 70%, and the internet and online commerce heavy sectors technology, communication services and consumer discretionary, which together make up more than 50% of the S&P 500 index.

“The mechanics of any MCAP index is that when it has inflows, it kicks off a positive self-reinforcing process where stocks are bought regardless of their underlying fundamentals (or any other variable). For instance, if the stock market is trading at a long-term unsustainable PE ratio of 100, the index fund still buys all stocks necessary to replicate the underlying index. Index funds are purchasing the largest, and often the most overvalued, companies of the index, inflating prices even further. This may sound all well and good, but it can go both ways with outflows automatically resulting in indiscriminate selling.

“Investors are increasingly aware of their growing concentration risk and are placing greater efforts on diversifying their portfolios. But when it comes to investing in passively managed investment strategies the risks are often overlooked and the vast majority of assets are allocated to the classic MCAP index. However, with greater digitisation of the investment management sector, custom indexing is now a reality, especially for the larger institutional investors that already possess the necessary knowhow and capabilities to research, create and run customised equity portfolios in-house.

“Increasingly, investors are dissatisfied with a one-size-fits-all approach of MCAP index products, and instead are customising their equity portfolios to be fully aligned with their individual investment and ESG policies, as well as their return expectations. We expect custom indexing to be one of the biggest growth areas in asset management.”