top of page
Search

Personalized Portfolio Construction

  • Vijay Poduri
  • Apr 16
  • 3 min read

Updated: May 7




In the early 1990s, the financial advice industry began offering a service to its clients called direct indexing. The origins of this service lay in tax management. High net worth investors with significant tax liabilities were looking for ways to reduce those liabilities. Direct indexing was an approach designed to meet this need.


The central idea was to hold all constituents of an index individually instead of buying an index fund. Holding all the constituents provides opportunities for tax loss harvesting since, in any given period, some constituents suffer losses even if the overall index has positive returns. For example, the S&P 500 index itself rose by 23.3% in 2024, but a third of its constituent stocks experienced losses, with 96 stocks losing 10% or more. The advisor or portfolio manager could then sell the loss making positions and utilize the accumulated capital losses to reduce the investor’s tax liability.


Over time, the idea of holding constituent stocks instead of shares of an index fund found other uses. One application was the diversification of concentrated portfolios. If a client portfolio already has a large position in a particular technology stock, the advisor may not want to get additional exposure to that stock coming from holding an index fund. In this situation, the desired portfolio would consist of the index constituents without the technology stock. 


A second such application was outcome-oriented investing, which involves specific goals such as reduced volatility or downside protection relative to the index. This again involves constructing the desired portfolio from index constituents directly.


In recent years, the trends towards increased customization and personalization have only accelerated. Newer generations of investors have demanded that their personal preferences be reflected in their portfolios. These preferences can include industry or sector exclusions, a desire for environmental, social, and governance (ESG) factors to be considered in security selection, or specific portfolio tilts towards or away from other factors. Indeed, the  target index fund may or may not be central to the process, so instead of direct indexing, a  more appropriate term might be personalized portfolio construction.


The composite screenshot below illustrates an example of such portfolio construction. Here, the use case is one in which the hypothetical client (1) does not wish to hold AAPL stock (perhaps because they already have a large position in it), (2) wants to exclude stocks from the Energy sector, and (3) also wishes to exclude Tobacco stocks. The goal is to construct a portfolio that still tracks the S&P 500 index reasonably well, while adhering to the specified constraints. 


We can further exploit a very useful feature of personalized portfolio construction, the ability to specify a minimum holding size. This basically enables the tracking of an index  without  the need to hold all (or even most) of the constituents. Typical broad market indices have many constituents with very small weights, which would have to be held in a fully replicated portfolio. Fully replicated portfolios have significant overheads in terms of time and effort needed for portfolio management.


The result of this portfolio construction exercise is a portfolio with 36 holdings and a portfolio volatility that is close to the volatility of the S&P 500 (the portfolio and benchmark volatilities are estimated by a proprietary Wealth NextGen model). Note that significantly smaller number of holdings compared to the index were the outcome of a constraint on the minimum position size of 1%. The smaller number of holdings makes the portfolio a lot more manageable.


Thus, portfolios customized specifically for individual clients, catering to their circumstances, are feasible and readily constructed with the help of a few settings in well-designed software. We feel this is the future of investing.


 
 
 

Comentários


bottom of page