Custom indexation is a more recent development in investment banking. It became very popular in the investment banking community in the beginning of the 21st century. Custom indexation allowed investment banks to compete with the asset management industry using their skills to design and test indices reflecting proprietary quantitative investment strategies. Initially, such strategies were reflecting long-only investment models, often based on single accounting factors. 

Over the last 5 years, more analytical work led to the design of multi-factor (including fundamental or macro-economic factors), asset allocation and absolute return indices, including fundamentally weighted indices. The latest developments include indices that simultaneously combine qualitative research and quantitative elements in the index creation process. Also new developments include the creation of rule based alpha indices that track a particular pattern of returns – also known as hedge fund replication. The latest developments include smart indices that include systematic risk management, embedded elements of principal protection, inherent derivative hedging, etc.

The use of custom indexation by investment banks has also led to the appearance of a non-linear index product offering. The European corporate and retail market in particular favours products and solutions that combine potential attractive return elements with risk reducing features such as principal protection. Arete Consulting estimates the size of the European market for this business at 738 bio euro (forecast for the end of 2009).

Investment bank’s custom index business is often conducted in co-operation with an external independent calculation agent that is either a data provider or an exchange. This is to avoid compliance issues potentially arising from conflicts of interests.