Investors over the last decade have increasingly turned to exchange-traded funds (ETFs) in an effort to target passive exposure to specific equity sectors. At the same time, financial advisors and their clients continue seeking cost-effective alternatives to ETFs—especially opportunities that add value through customization and tax-loss harvesting in separately managed accounts (SMAs). Not surprisingly, interest in customized individual solutions has turned to fixed income allocations and shined a spotlight on the possibility of a similar approach to managing bond portfolios. In response, Parametric developed an investment process that manages an investor’s fixed income SMA based on their particular objectives and guidelines.
Regardless of the asset class, the investment objective of direct indexing remains the same: to provide similar risk and return experiences relative to the investor’s chosen benchmark. However, the structural differences between the two equity and fixed income markets—liquidity, constituent characteristics and number, and minimum trade size—demand that portfolio managers rely on different ways to achieve those goals. Optimization proves to be the most effective method for constructing a low-tracking-error equity portfolio, but the stratified-cells approach is a more practical way to construct a bond portfolio. While the stratified-cells methodology is quite common in fixed income, it’s customarily been employed in commingled vehicles like index-based mutual funds and ETFs.
What are the differences between equities and bonds?
Although there’s significant overlap in issuers between the S&P 500® and an investment-grade (IG) corporate bond index, there are also key distinctions due to differences in the underlying markets. Fixed income indexes tend to contain many more securities than equity indexes. For example, the ICE BofAML US Corporate Index contains over 8,000 constituents, many of which don’t trade daily. This difference is the result of public companies typically having only one class of stock, while IG issuers may have many bond issues outstanding with vastly different coupons, maturities, issue dates, and liquidity.
Monthly rebalancing can materially change the characteristics of a bond index depending on the size of the new issuance calendar and the number of bonds removed that no longer meet the index criteria for inclusion. As a result, an IG corporate bond index will have a higher turnover than a comparable equity benchmark. Since the cost of trading a corporate bond is also higher than the cost of trading the company’s stock, it’s important to minimize transaction costs by limiting turnover and using a liquidity screen that focuses on bonds with relatively low bid-ask spreads.
Even though it’s possible to transact in fractional shares, IG corporate bonds typically require trades with a minimum par of 2,000 and increments of 1,000 afterward. This limits the number of positions that can be practically owned in an SMA. While still well diversified, a customized fixed income portfolio may have more concentrated positions than an equity SMA. To mitigate higher idiosyncratic risk, it’s important to employ forward-looking fundamental research aimed at providing downside principal protection.