The S&P 500, originally designed as a benchmark index, has become a popular investment vehicle, particularly through ETFs. However, at BX Index, we question the wisdom of owning all 500 stocks indiscriminately. Our approach focuses on quality over quantity, asking: Why not own just the best 250 stocks? Or the top 125? Or even the highest-ranked 50?

We believe that condensing and concentrating a portfolio leads to purer outcomes. Much like in winemaking, where the finest grapes are reserved for premium wines, we advocate for investing in the best, not the most. Our research indicates that an optimal number of stocks, typically between 10 and 50, can achieve superior risk-return characteristics compared to broader indices.

The emerging field of Direct Indexing often involves creating large baskets of stocks, frequently starting with the S&P 500 and eliminating certain elements based on various criteria. This approach often results in portfolios of 300-400 stocks, which are then managed to track a benchmark closely.

At BX Index, we challenge this notion. We believe that by targeting smaller, more focused indices, investors can potentially outperform traditional benchmarks while maintaining a more manageable set of holdings – think 30 stocks versus 300 or more. This approach not only simplifies portfolio management but also opens up opportunities for enhanced performance.

As it relates to financial advisors giving advice to their clients, we believe that once a client customizes the portfolio, the advisor is providing a tool not a solution. The question of ownership in customized portfolios is complex, especially when considering the role of financial advisors as fiduciaries. While customization works well for family offices and institutions, we believe that most individual clients don't actually want to design their own index or own hundreds of securities.

Our philosophy is that clients are looking for tailored solutions designed by financial professionals. These solutions should create the best risk-adjusted performance based on the client's specific goals, rather than asking clients to become portfolio managers themselves.

Once customized, we wonder who owns the performance? If a client wants to eliminate certain industries, sectors or factors it’s likely there will be periods of significant underperformance. As an example, if a client wants to eliminate AI, Social Media, and Big Tech from their portfolio…then they own that performance along with the advisor who gave them that tool.

BX believes that customization would mean identifying the best risk/return characteristics for each client, and not randomly eliminating stocks and sectors from the portfolio.

The intersection of Direct Indexing and Unified Managed Accounts (UMAs) presents challenges, particularly in areas like tax-loss harvesting and managing large numbers of holdings. However, we envision a future where these concepts can be integrated more seamlessly, offering cleaner, more comprehensive investment solutions.

Today, most of direct indexing is done in a stand alone account, due to the large number of holdings, and tax loss harvesting. By owning smaller indexes or baskets it is easier to execute and understand the sleeve reporting. It's also less likely that you will have overlap issues from one index to the other. It’s also easier to trade, rebalance, and monitor. It also makes more sense to tax loss harvest at the household level versus the account level, otherwise the systems aren't talking with one another.

We like to target UMAs to have 100 or fewer holdings. Not only does the performance stand out, but makes all of the other fintech pieces easier to manage.

We believe that clients desire a sense of ownership in their investments, whether it's a stock, an ETF, or a strategy. The excitement of ownership is a powerful motivator, and our approach aims to provide this while maintaining portfolio efficiency. We have identified a number of strategies from around the world (indexes/SMAs) that are concentrated by owning 10 stocks, The strategies can be rebalanced quarterly with a reasonable amount of turnover. Rather than just buying and holding stocks, or a blind ETF or Mutual Fund, or an SMA with 75 stocks, clients seem to like owning 10 stocks. They also know that you just can't hold them forever, so they tend to appreciate the periodic readjusting that takes into account valuation.

While low-cost beta investing has its merits, we focus on improving the quality of beta exposure. Our approach aims to provide directional market exposure while enhancing the potential for outperformance through strategic selection and weighting of holdings.

An example of this would be for a client to have Large Cap Value exposure in their account done with one ETF. We think a better way is to apply several value filters on the basket of stocks in the ETF, and select the top 10 or 20 or 30 or 40. This allows for the chance to outperform the ETF and the benchmark, and it’s still cheap.

Much like a high-quality pizza relies on superior ingredients, we believe in the power of open architecture in investment management. By incorporating a variety of approaches, teams, and styles, we create more robust and diverse investment solutions. Over the course of a year, the BX team will interview 100 money management firms. We will then select the ones that we believe can provide superior portfolios. We will likely add ten per year, and 25 new strategies per year.

Our approach is to select only strategies that work well in an index structure, and can stand on its own two feet. Where you really feel the difference is in the blending or model creation. Designing a multi- index strategy is just like making a mouth-watering pizza, it all starts with using the best ingredients.

Just as master chefs limit their spices to maintain flavor clarity, we avoid over-diversification in our portfolios. While we offer various models and investing styles, we carefully curate our selections to prevent dilution of performance potential. There have been many studies that point to achieving significant diversification with a few number of holdings (i.e. 8, 12, 20) and so on.

The flip side is not researched that well. Meaning at what point do you have so many holdings that nothing stands out? We believe over-diversification can dilute the optimal risk and return. So why is it done this way? The same reason that an average chef just puts everything into a pot, which is lack of confidence.

Balancing innovation with prudence is crucial in investment management. While we strive for creative and diverse solutions, we never compromise on thorough due diligence. Our approach aims to find the sweet spot between conventional wisdom and cutting-edge strategies, always with the client's best interests in mind.

At BX, we pride ourselves in being open architecture and agnostic. We can work with any money manager, and blend just about anything into an index or a model. By eliminating any conflicts of interest, we can just focus on finding the best firms and the best strategies. Using this approach, we also free up our clients to have access to many different philosophies and styles of asset management research.

Managing risk is paramount to a client model or strategy. It is critical to focus on reducing portfolio volatility and maximum drawdowns, aiming to protect clients from severe market downturns while maintaining exposure to potential upside.

We like two approaches to help solve for this. The first is to allocate based on dynamic correlations. The second is to have some non-emotional exposure to strategies with built-in, meaning when a clear downtrend has been identified to allow for a choice other than remain fully invested, such as cash or other.

No investor likes the dips of rollercoasters. Designing a ride with smaller dips is the tricky part. We spend a lot of time researching the two approaches for this very reason.

We recognize the importance of balancing core and satellite investments in portfolio construction. Our approach refines the traditional core-satellite model, optimizing the mix of passive and active strategies to enhance overall portfolio performance.

As we see it, the basic challenge with core and satellite is to define the satellite, and how to rotate in and out of it. Without this, it could just become an anchor versus a satellite. Another way to look at this is to think of satellites as thematic. We have seen great long term themes perform very badly in the short run. The goal is for satellites to enhance the return. So we prefer satellites that are dynamic and are built for various conditions.

BX Index acknowledges the value of tactical and thematic investing when applied judiciously. We carefully evaluate emerging trends and technologies, translating compelling concepts into actionable investment strategies that complement our core offerings.

In investing, as in life, the cheapest option isn't always the best. While cost-efficiency is important, we prioritize quality and performance potential in our investment selections. Our rebalancing approach focuses on reallocating to the best choices, not merely the cheapest options.

We recently did a simple study exploring a 60/40 (SPY/AGG) and the best time to rebalance it between 1/1/2023 and 6/30/2024 or 18 months. The performance answer was to not rebalance at all during this time, or you were simply throwing good money after bad. This is not always the case, but it's a great example of the principal to add money in the rebalancing that will produce performance, and keep the client risk tolerance in line.