FTSE Russell Insights

Direct indexing: selecting
the right index

Emerald Yau

Maria Elisa Giraldo

Manager, Account Based Marketing
Michael DeMilio

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.

What makes an index

Image identifies 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.

MSFT
+3,270%
IPO - 3/1986
Added to Russell - 6/2002
Added to S&P - 6/1994
TSLA
+17,192%
IPO - 6/2010
Added to Russell - 9/2012
Added to S&P - 12/2020
SQ
+936%
IPO - 11/2010
Added to Russell - 9/2010
Added to S&P - 12/2020
AMZN
+1,923%
IPO - 3/1986
Added to Russell - 6/2002
Added to S&P - 6/1994
MRNA
+1,638%
IPO - 12/2018
Added to Russell - 3/2019
Added to S&P - 7/2021
NFLX
+2412%
IPO - 5/2002
Added to Russell - 6/2002
Added to S&P - 12/2010

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 read the full paper - The Direct Indexing Opportunity 2022.

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