Patrick O'Shaughnessy on the Next Big Thing in Passive Investing

Episode Summary

Executive Summary: The episode examines custom indexing as the next evolution in passive investing, arguing that falling trading costs, fractional shares, and software now make personalized, tax-aware portfolios feasible. Patrick O’Shaughnessy explains how custom indexes can reflect personal preferences, human capital exposure, and tax situations while remaining broadly diversified and benchmarked to simple market indexes.

Main Topics: Passive investing as a technological evolution (Priority: 5/5): Tracy and Joe frame passive investing as a post-GFC default that became widely accepted through ETFs and index funds, but now faces new personalization trends and renewed interest in active-style behavior. Custom indexing vs. direct indexing (Priority: 5/5): Patrick distinguishes direct indexing as tax-loss harvesting on top of a third-party benchmark, while custom indexing allows investors to design the index itself around preferences, taxes, and exposures. Technology enabling personalized portfolios (Priority: 5/5): The conversation stresses how free trading, cheaper accounts, and fractional shares reduce barriers to owning baskets of stocks directly, making custom indexing operationally practical. Tax optimization and personalization (Priority: 5/5): A major pitch for custom indexing is the ability to harvest losses, manage capital gains budgets, and tailor holdings to personal values or occupational risk, improving after-tax outcomes. Quant research and software as competitive moats (Priority: 4/5): Patrick argues the industry’s competitive frontier is now software development plus quantitative research, not just index construction, and that firms with these capabilities can rapidly generate new client-specific portfolios. Threat and coexistence with ETFs and mutual funds (Priority: 4/5): Custom indexing may compete strongly with ETFs for taxable investors with lower-turnover strategies, while ETFs remain superior for high-turnover approaches where tax efficiency and the wrapper itself matter most. Patrick O’Shaughnessy’s investing philosophy (Priority: 3/5): The interview closes on Patrick’s preference for learning through concrete business detail, diversification, and selective exposure to emerging areas like crypto and early-stage technology.

Key Arguments: Passive investing is not a binary but a spectrum; custom indexing simply moves an investor along that spectrum toward more personalized, still-diversified exposure. Index funds and ETFs were themselves major technological innovations, and custom indexing is presented as the next step in the same progression. Lower trading costs, cheaper brokerage accounts, and fractional shares remove historical barriers to directly owning tailored baskets of stocks. Investors have unique tax, occupational, and ethical preferences, so a one-size-fits-all index is increasingly unnecessary. Owning stocks that overlap with one’s job or human capital can be inefficient; custom indexing can reduce concentration risk by avoiding redundant exposures. Tax-loss harvesting can improve after-tax returns and may become more available as minimums and costs fall. Firms competing in this space need both software infrastructure and quantitative/data-science research to scale customization efficiently. ETFs will remain optimal for high-turnover strategies, but custom indexing is a serious alternative for taxable investors in lower-turnover portfolios. Detailed understanding of businesses and industries produces better investing intuition than abstract theory alone.

Data Points: Stock Movers report length: five minutes or less - Bloomberg promo describing short audio stock reports OSAM custom indexing platform assets: about $2 billion - Patrick says Canvas is approaching this level after roughly 1.5 to 2 years Unique indexes on Canvas: about 80% - Patrick says most indexes built on the platform are fully unique Lowest price for the platform: 20 basis points - Patrick describes current pricing for custom indexing services Potential further fee decline: 10 basis points over 10 years - Patrick suggests costs may fall further over time Example tax budget: $100,000 in capital gains taxes - Example of a client’s explicit customization constraint Cap on capital gains desired by another client: $0 - Example of a client wanting no realized capital gains Tax crossover turnover threshold: 20-25% annual turnover - Patrick says this is roughly where ETF tax advantages become more important Low-turnover segment example: under 20% turnover - Patrick argues custom indexing is especially competitive here Human capital horizon: 50 years or more - Patrick uses his own expected working life to justify portfolio diversification Quant trading scale: thousands and thousands of separate accounts - Patrick explains the scale of software infrastructure OSAM had built before Canvas Interviewed business breakdown duration: 1.5 hours - Patrick mentions a Wyndham Hotels deep dive on Colossus

Pivotal Quotes: "custom indexing is just the next natural stop in that journey" — Patrick O'Shaughnessy: Describing the evolution from mutual funds to ETFs to personalized indexing "Why should everybody own the same 500 stocks in the S&P 500?" — Patrick O'Shaughnessy: His central argument for tailoring portfolios to individual circumstances and preferences "Diversification is the only rational deployment of ignorance." — Patrick O'Shaughnessy: His framing of crypto and portfolio construction under uncertainty

Implications: Custom indexing could reshape wealth management by giving taxable investors, employees with concentrated industry exposure, and values-driven clients more personalized, tax-aware portfolios. ETFs remain powerful, but fund management may shift toward software-driven customization.