When you’re a hammer, everything looks like a nail.
With the recent explosion of index mutual funds and ETFs, the menu of investment options available to investors continues to expand. As of August 2023, there are over 300 Exchange Traded Products on the Australian Stock Exchange, representing more than $150Bn AUD. As the number of listed exposures continues to grow, it is important not only to understand the benchmark being used, but also how each specific index is being replicated.
Much has been written about financial advisers & wealth managers looking to differentiate themselves from the pack, particularly in a world of universally adopted fee-based models. The customisation benefits of direct indexing have already delivered a differentiated & personalised investor experience abroad, with the trend already gaining traction on home soil. At Briefcase, we fully anticipate this demand to swell, as education ramps up and financial advisors come to grips with the flexibility & mass customisation their clients are demanding.
In the many conversations I’ve had in recent years with financial advisers, family offices & wholesale investors, the mechanics behind index replication (“how does my ETF provider deliver index performance – or fail too”) is often misunderstood and rarely discussed.
Index replication, in its most basic form, is a disciplined way to mirror market movements. However, not all methods are created equal. This becomes even more important as investors seek to customise their investment portfolios to reflect their personal & unique needs, wants & constraints.
“My personalised portfolio”
Once a set of securities have been defined (what we call “the investible universe”), such as all shares in the S&P/ASX200, Briefcase technology is then able to incorporate each investor’s values, ESG preferences & tax considerations. Once securities have been removed from the investment universe, we consider how best to deliver the index returns (S&P/ASX200 index in this instance), net of the shares excluded.
Equity ETF
Listed, unitised index fund, holding all securities in an equity index.
Direct Index
Similar exposure to an equivalent ETF but with direct ownership of all underlying shares, and no wrapper (e.g., not a fund).
Personalised Portfolio
Personalised Portfolio allows investors to swap individual shares to potentially take advantage of tax losses, incorporate personal preferences such as ESG, while still maintaining equivalent market exposure.
But if stocks are taken out, how can you still replicate the index?
When looking at an index replication strategy, especially when the full investible universe can’t be utilised (the investor excluded it for ESG reasons as an example), we must consider multiple factors in replicating the target index. What we would call…
“The first principles of index replication”
1. Tracking Accuracy
The investment objective being “to deliver investment performance of the target index” (e.g., S&P/ASX 200). Performance beyond point-to-point returns, but also their pattern of returns.
2. Cost Efficiency
Portfolio management isn’t frictionless. Transaction costs & portfolio turnover are unavoidable. The goal is to minimize these intrinsic expenses.
3. Risk Management
The focus being to reduce idiosyncratic risk through diversification.
4. Operational Simplicity
The portfolio management function must be straightforward from an implementation, daily-monitoring & rebalancing perspective.
How is portfolio customisation managed today?
Many fund administration platforms used by wealth managers & financial advisers purport to have re-allocation capabilities. ‘Take out security A and re-distribute the sale proceeds into the remaining assets in the portfolio’.
In almost every instance, this method is a ‘Pro Rata’ re-allocation. Pro Rata translates from the Latin meaning “in proportion”, describing a process where whatever is being allocated is distributed in proportion to the original, relative weights.
In simple terms, removing a security from the portfolio results in excess cash that must go somewhere in the new portfolio. This naïve approach has material implications on the final portfolio.
Tracking Error
Active risk (or standard deviation of excess portfolio returns) is due to active decisions made by a wealth manager (removing shares of security “A” from a portfolio is an active decision!).
There is no mathematical framework to actively minimise tracking error when using a pro-rata approach, which can deviate significantly over time.
Pro-rata re-allocation, whilst simple and quick to implement, makes it appear attractive for those looking for operational ease, where mathematical sophistication isn’t available. More importantly, this simplicity & lack of sophistication can (and does) come at the cost of longer-term portfolio health and effectiveness. A pro-rata approach has two material drawbacks:
1. Lack of Risk Management
Pro-rating of a portfolio to accommodate exclusions overlooks correlations between assets, leading to potential risk concentrations.
2. Lack of Dynamism
Pro-rata does not adapt to market changes, making it less precise over time.
Optimisation: The More Thoughtful Approach
At Briefcase, we utilise an institutional approach to create custom portfolios for individual clients.
Offering custom portfolios to accommodate clients’ personalisation requests (ESG, tax optimisation, trimming highly appreciated security positions & unique exclusions) requires many technological components.
The nerve centre of our investment approach at Briefcase is our use of proprietary optimisation technology, allowing us to build the best possible portfolios for each & every client account. Portfolio optimisation, as opposed to a naïve pro-rated approach, aligns closely with the goals of accurate index tracking, cost efficiency over time, and robust risk management. Our approach aims to ensures the ongoing health and performance of the portfolio. Whilst portfolio optimisers have been used by sophisticated investment firms for years, these tools are not only highly complex, but they are also unsuitable for the modern financial adviser looking to differentiate their offering across hundreds of clients. By adhering to optimisation as the preferred strategy, Briefcase not only upholds the scientific rigor that underlies modern portfolio theory, but also fulfills the fiduciary duty to managing risks effectively.
In the context of index replication, optimisation is not just an option; it must be considered best practice for those aiming for precision and excellence in portfolio management. Financial advisors can now seamlessly accommodate investors’ desires, providing a highly differentiated offering, with access to the right tools for the job.
At Briefcase, we have brought existing portfolio management tools into the 21st Century. We’ve also built some new ones - how we record & manage information for compliance, reporting, performance & risk management, tax, client service & 3rd party integration, modernising the investment management function for our clients.
The transition towards direct indexing requires the rethinking of many aspects of the portfolio management & client service functions. At Briefcase, we firmly believe institutional trading and wealth management are sufficiently different enough to merit a fresh approach.
For access to our tools to help you differentiate, emails us at enquiries@briefcase.au