Patrick O'Shaughnessy: 'Custom Indexing Unlocks a Lot of Benefits'

Episode Summary

Executive Summary: Patrick O’Shaughnessy argues that investing is shifting from product-centric portfolio construction toward software-enabled mass customization. He explains why custom indexing can better accommodate ESG values, tax needs, and income goals, and why firms like his are building both research and platforms to meet these demands. He also reflects on factors, the evolution of asset management, and lessons from podcasting and leadership.

Main Topics: Custom indexing as the new core of portfolio design (Priority: 5/5): O’Shaughnessy says technology, zero trading costs, and fractional shares make individualized portfolios feasible at scale, allowing advisors to tailor exposures, taxes, ESG, and income rather than rely on one-size-fits-all funds. ESG customization and trade-offs (Priority: 5/5): He frames ESG primarily through tracking error and explicit trade-offs, arguing investors should understand the performance cost of values-based tilts and measure both returns impact and portfolio characteristics. Tax management and direct indexing (Priority: 5/5): Custom indexing’s strongest advantage, in his view, is tax optimization—especially tax-loss harvesting and transition management from concentrated positions—where direct indexing can beat ETFs on after-tax outcomes. Income and retirement solutions through software (Priority: 4/5): He describes using custom indexing to fine-tune income-oriented equity strategies and imagines customizable target-date and retirement income products that blend planning and portfolio implementation. Factors, valuation, and what still works (Priority: 4/5): O’Shaughnessy discusses the decay of some historical factor edges, especially small-cap, while defending diversification across factors and noting that value could rebound if valuations normalize or legacy firms adopt new technologies. Business transformation in asset management (Priority: 4/5): He says the industry’s competitive frontier has moved from alpha to quant research plus software development, requiring firms to break silos and build collaborative, technology-driven organizations. Podcasting, learning, and leadership (Priority: 3/5): He credits podcasting with broadening his thinking, emphasizes learning by sharing, and says the best lesson from his father was autonomy—giving talented people room to lead.

Key Arguments: ESG should be handled as a customized preference set, with tracking error used to quantify the cost of deviating from a benchmark. Most investors either do not know ESG jargon or simply do not prioritize it; a meaningful minority does, and advisors should serve both groups differently. Custom indexing needs to report both returns attribution and ESG characteristics so investors can judge whether the customization is worth it. ESG tilts may be expensive, but price alone does not determine value; better ESG companies could still outperform through stronger growth or quality. Keeping ESG separate from the core financial portfolio is a valid choice; the right answer is to empower investor choice rather than impose a single model. Mass customization is enabled by free/near-free trading, fractional shares, and software infrastructure, making custom indexing scalable beyond high-net-worth clients. The biggest advantage of direct indexing is tax efficiency, especially loss harvesting and tax-aware transitions out of concentrated positions. Direct indexing can be evaluated by comparing after-tax outcomes to ETFs; he cites about 80 basis points of expected advantage over a 10-year horizon. Retirement income products can also be customized by choosing where to sit on spectra such as yield versus volatility, rather than accepting an ETF’s fixed rule set. Asset management’s winners will increasingly be firms that combine quantitative research with software development. Some traditional factors remain meaningful, but they must be diversified and updated; price-to-book is less useful in an intangible, software-driven economy. Value could outperform if growth valuations compress or if value companies adopt technologies that improve earnings growth. Podcasting helped him learn broadly outside quant investing, and sharing knowledge creates value that exceeds what can be captured internally. Good leadership often means giving talented people autonomy, as his father did for him.

Data Points: Estimated share of investors actively adjusting for ESG: 15–20% - O’Shaughnessy says a vocal minority cares deeply about ESG and adjusts portfolios accordingly. Canvas users adjusting for ESG: ~15–20% - He compares investor behavior to roughly the share of platform users who opt into ESG customization. Accounts on the platform with unique settings: Almost 80% - He says most accounts are customized in some form, even if not for ESG. Advisors/investors not adjusting for ESG: ~80% - He notes the majority do not customize for ESG, though that may change over time. Expected direct-indexing advantage vs. ETF: About 80 basis points over 10 years - He cites research comparing after-tax outcomes before liquidation and after liquidation. Direct-indexing advantage range: 0 to 250 basis points - He says outcomes vary widely depending on the client and circumstances. Year of his career start: 2007 - He references entering the industry just before the global financial crisis. Early RIA cohorts using the platform: First cohort and second cohort onboarded - He describes initial partners as investment-savvy RIAs fluent in factors, taxes, and loss harvesting. Podcast output: Missed very few weeks over five years - He describes consistent production of Invest Like the Best. Point-in-time crisis reference: March 19, 2020 - He uses this as an example of client behavior during market stress. Taxable loss harvesting during 2020: Significant net taxable losses - He says portfolios could be up yet still generate losses for tax purposes in 2020. Value vs. growth valuation spread: Widest ever by a lot, even wider than March 2000 - He argues growth valuations have become extreme relative to value. Firms size ranking when he became CEO: 35th to 41st range - He says O’Shaughnessy Asset Management was relatively small and inertia was still strong.

Pivotal Quotes: "“We think of that as a nice measurement of what I'll call cost.”" — Patrick O’Shaughnessy: On using tracking error to frame ESG trade-offs for investors. "“Why in the world wouldn't you do both?”" — Patrick O’Shaughnessy: On combining strong financial planning with customized portfolio implementation. "“The competitive frontiers have changed a lot. And now they are two things: quantitative research and software development.”" — Patrick O’Shaughnessy: On how asset management firms will differentiate in the future.

Implications: Advisors should expect more software-driven personalization in portfolios, especially around taxes, ESG, and income. Firms that pair quantitative research with scalable technology may gain an edge, while investors will need clearer reporting to understand trade-offs.