With increasing awareness and a growing number of new providers, rules-based, customized, and tax-efficient solutions like direct indexing and bond ladders are expected to expand at an annualized rate of 12% over the next five years1—outpacing mutual funds and ETFs.
As client demand for personalized investment strategies continues to increase, direct indexing has become one of the fastest growing segments within the managed account space. According to Cerulli Associates, direct indexing was the leading category for manager-traded SMAs, with $512 billion in assets as of the second quarter of 2023.
Among the top manager-traded categories, right behind direct indexing, stand the municipal and taxable fixed income segments with $451 billion and $248 billion, respectively. Providers of those solutions offer both actively managed strategies and more systematic, rules-based strategies like bond ladders.
Parametric has been a pioneer and a leader in both direct indexing and bond ladder solutions. We wondered if comparisons could be made between these strategies. Could a bond ladder be considered the direct indexing of the fixed income space? We recently published our analysis and findings in the Journal of Beta Investment Strategies.2 Here’s a brief summary.
Similarities of equity direct indexing and bond ladders
Direct indexing has historically been considered an equity investing strategy. With equity direct indexing, an investor purchases some or all of the stocks in an index to obtain its market beta. Owning individual stocks instead of an index or ETF creates certain opportunities. Investors can use tax-loss harvesting to generate tax alpha, potentially leading to higher after-tax returns. Investors can also introduce levels of customization not otherwise available.
Like equity direct indexing, municipal, corporate or Treasury ladders also follow a highly customizable, rules-based approach to investing. Investors and their advisors work together to build equal-weighted laddered portfolios that can be customized for credit quality, duration, maturity range and other characteristics. Each laddered portfolio will likely be constructed with different securities than other portfolios, but they can be built with similar maturity, quality, risk, return and other traits—resulting in portfolios that capture the market beta of a fixed income asset class across the targeted maturity range.
We offer tax-advantaged core bond market exposure
Bond ladders may deliver many of the same benefits as equity direct indexing strategies—possibly even improving upon them in some ways.
Taxes are a crucial element in direct indexing, and tax-loss harvesting may have added benefits in a fixed income portfolio compared to an equity portfolio. With an equity portfolio, unless new cash is added, tax-loss harvesting opportunities may run out as the cost basis on individual securities is continually reset lower. Contrast that with a fixed income portfolio, where proceeds from maturing bonds, calls and coupons offer ongoing opportunities for reinvestment and resetting of the cost basis.
A bond ladder can also be constructed with the investor’s own tax rate in mind—along with careful consideration of the tax treatment of different bond sectors like US Treasurys, corporates and in-state versus out-of-state municipals. For example, a traditional municipal bond buyer in a mid-tier tax bracket may benefit from a more tactical but still rules-based approach—one that aims to optimize the allocation between tax-exempt and taxable bonds based on their tax rate and the relative value between sectors, always buying the bond with the highest after-tax yield.
Bond ladders may also offer returns that are easier to predict. With no market timing of interest rates, yield curve or credit, laddered bond portfolios lend themselves to more dependable return outcomes relative to active portfolios. Returns and potential tax savings from loss harvesting can be estimated using an interest rate scenario calculator.
ESG factors have become another popular element of customization within the equity direct indexing space. Both corporate and municipal bond ladder solutions also offer investors the ability to align their fixed income exposures with their values. In the corporate space, investors can choose from a variety of ESG screens based on business involvement, reporting transparency or ESG analyst ratings. In the municipal space, investors can filter on the bond’s use of proceeds to invest in projects that have positive social or environmental impacts.
The bottom line
A bond ladder can be an attractive vehicle for implementing a direct indexing–like approach in fixed income. While tracking a specific index may be less of a focus than with equities, the two approaches share similar potential benefits around personalization, flexibility and tax advantages.
The systematic, rules-based and evenly weighted structure of ladders can support stability in duration and may make performance more predictable in changing interest rate environments. SMA laddering also opens the door to multiple tax-optimization strategies through tax-loss harvesting and tactical allocation between taxable and tax-exempt fixed income sectors.
1 “The Case for Direct Indexing—Differentiation in a Competitive Marketplace” by Cerulli Associates, December 2022.
2 “Bond Ladders—Unlocking Direct Indexing Opportunities in Fixed Income” by Issac Kuo, Jonathan Rocafort, Eric Bland and Stephanie Fish, Journal of Beta Investment Strategies, Direct Indexing Special Issue, Fall 2023.
