Index investing continues to evolve since its inception, from a rudimentary representation of market performance to a more sophisticated and integral component of institutional investment strategies. The broad acceptance and implementation of indexing are both now ubiquitous, making index funds and the decisions across benchmarks key inputs into asset allocation and portfolio construction. The evolution of indexing encompasses several key areas, including passive equity investing, fixed income investing, and more recently, index customization, which highlights an important shift in how investors approach the uses for indexing.
Evolving Approaches to Indexing
Traditionally, index investing was synonymous with passive equity strategies and funds that aimed to replicate the performance of well-known benchmarks such as the S&P 500 Index. As market dynamics have evolved, so too have the methodologies – the rules and design of indexes – and therefore the ways in which indexes are employed.
Fixed income indexing, for example, has gained traction as institutional investors recognize the benefit of incorporating cost-effective fixed income strategies within portfolios. This transition was marked by significant advancements in technology, enabling more precise means to measure and track fixed income markets. As a result, investors have increasingly sought out more tailored strategies that address specific market segments, align with risk tolerances, and allow for flexibility in response to changing economic conditions.
At the core of effective index investing is the critical decision regarding benchmark selection. The choice of benchmark can influence investment performance, making the indexing decision an active engagement rather than a passive one. Institutional investors may find that the benchmark indices originally chosen some years ago require reevaluation in light of methodological updates or evolving market conditions. This reassessment is increasingly necessary as even seemingly minor methodology differences can result in unexpectedly different and non-intuitive outcomes.
Custom Indexing: Opportunities and Challenges
In this context, the advent of custom indexing has emerged as a timely and innovative solution, allowing investors to tailor their portfolios according to their specific objectives or risk profiles. Custom indexing presents a similar opportunity for asset managers and investors to develop bespoke portfolios that provide flexibility to pivot in response to a dynamic market. However, creating a custom index necessitates a thoughtful and meticulous design process to mitigate unintended risks and consequences associated with non-standard benchmarks relative to market-capitalization weighting schemes. Key considerations might include tilting towards specific investment styles, managing geopolitical risks, or ensuring optimal market exposures to align with the overall goals and objectives.
Furthermore, the dynamics of fixed income indexing underscore both its opportunities and challenges. Unlike the equity markets, which are comparatively straightforward to replicate, fixed income markets require a more nuanced approach due to the diverse structure of debt securities, number of issues, and liquidity constraints. Recent innovations within fixed income indexing includes the growing use of systematic and customized indexing. These approaches enable investors to tailor strategies that may focus on specific objectives, such as capturing incremental income while systematically selecting credits that may be undervalued using spread and default-based metrics. Regardless of the approach, these strategies require diligent monitoring to navigate the inherent risks associated with fixed income investing.
The journey toward designing and implementing a custom index begins with a clear understanding of investor’s objectives and framework for risk controls, and how passive strategies may complement the use of active ones within a portfolio. Successful outcomes often hinge upon collaboration between institutional investors and skilled asset managers who possess a deep understanding of index methodologies and portfolio implementation. A well-designed custom index strategy not only aligns with the overarching investment goals but also adequately addresses performance attribution, ensuring transparency and accountability.
Conclusion
The innovations in indexing represent an important evolution in the investing landscape that brings more power to investors. As investors increasingly confront a complex array of market conditions, the ability to customize index solutions offers a strategic advantage. By partnering with knowledgeable asset managers, institutional investors can exploit indexing tools to enhance portfolio performance while addressing specific needs that conventional indexing approaches might not fulfill.
IMPORTANT INFORMATION
Northern Trust Asset Management (NTAM) is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Northern Trust Asset Management Australia Pty Ltd, and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.
Issued in the United Kingdom by Northern Trust Global Investments Limited, issued in the European Economic Association (“EEA”) by Northern Trust Fund Managers (Ireland) Limited, issued in Australia by Northern Trust Asset Management (Australia) Limited (ACN 648 476 019) which holds an Australian Financial Services Licence (License Number: 529895) and is regulated by the Australian Securities and Investments Commission (ASIC), and issued in Hong Kong by The Northern Trust Company of Hong Kong Limited which is regulated by the Hong Kong Securities and Futures Commission.
For Asia-Pacific (APAC) and Europe, Middle East and Africa (EMEA) markets, this information is directed to institutional, professional and wholesale clients or investors only and should not be relied upon by retail clients or investors. This document may not be edited, altered, revised, paraphrased, or otherwise modified without the prior written permission of NTAM. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. NTAM may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, its accuracy and completeness are not guaranteed, and is subject to change. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor.
This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. Indices and trademarks are the property of their respective owners. Information is subject to change based on market or other conditions.
All securities investing and trading activities risk the loss of capital. Each portfolio is subject to substantial risks including market risks, strategy risks, advisor risk, and risks with respect to its investment in other structures. There can be no assurance that any portfolio investment objectives will be achieved, or that any investment will achieve profits or avoid incurring substantial losses. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Risk controls and models do not promise any level of performance or guarantee against loss of principal. Any discussion of risk management is intended to describe NTAM’s efforts to monitor and manage risk but does not imply low risk.
Past performance is not a guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by NTAM. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Net performance returns are reduced by investment management fees and other expenses relating to the management of the account. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise. For U.S. NTI prospects or clients, please refer to Part 2a of the Form ADV or consult an NTI representative for additional information on fees.
Forward-looking statements and assumptions are NTAM’s current estimates or expectations of future events or future results based upon proprietary research and should not be construed as an estimate or promise of results that a portfolio may achieve. Actual results could differ materially from the results indicated by this information.
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