Over the past three years, Envestnet's Quantitative Portfolios (QPs) offering has grown by 40 percent annually in accounts and advisors. According to Cerulli, total direct index industry assets were $434 billion at the end of 2022, and they expect direct index assets to grow at a 12% clip over the next four years – outpacing the growth of mutual funds and ETFs over that same period.1 In this blog series, industry leaders from our quantitative asset management unit, QRG Capital Management, Inc., will share insights designed to help advisors customize their clients’ portfolios to meet a variety of needs.
Direct indexing has generated significant attention in recent years as a means of personalizing an investment strategy. Traditionally associated with equity portfolios, direct indexing involves creating a customized separately managed account (SMA) portfolio that replicates characteristics of a market index while allowing for specific adjustments to meet the investor's unique preferences, such as tax optimization or exclusion of certain sectors or individual securities. However, the concept of direct indexing can also be extended to bond portfolios, including through the use of bond ladders.
Bond ladder portfolio basics
A bond ladder is a strategy in which an investor purchases a series of bonds with different maturities, spreading the investment across a range of time horizons. As each bond matures, the principal is either reinvested into a new bond at the far end of the ladder or used according to the investor's needs. This approach provides a consistent income stream, reduces interest rate risk, and maintains liquidity by ensuring that a portion of the portfolio matures regularly. Unlike an actively managed or passively indexed bond portfolio, a bond ladder is designed to be a buy-and-hold strategy.
Bond ladders as directing indexing
Direct indexing allows investors to hold an optimized portfolio of individual securities that replicate characteristics of an index rather than buying a traditional mutual fund or ETF. Holding individual securities provides greater control over tax outcomes, investment exclusions, and overall portfolio customization. Clients can optimize their holdings based on their tax situation, income needs, ESG/sustainability preferences, or specific investment goals, making it a powerful tool for personalized client outcomes.
Bond ladders can be considered a form of direct indexing for several reasons:
- Customization and personalization: Just as direct indexing in the equity asset class allows for the customization of an index, bond ladders enable investors to tailor their fixed-income portfolios according to their risk tolerance, income needs, and market outlook. Investors can select bonds based on credit quality, issuer type (i.e., corporate, municipal, government), and duration, allowing them to create a bond portfolio that meets their unique investment objectives.
- Tax efficiency: Similar to equity direct indexing, bond ladders offer opportunities for tax efficiency. In the case of bond ladders, tax efficiency is primarily achieved through enabling investors to select a ladder consisting of municipal securities. In many cases municipal bond ladders can be tailored to select bonds only from the investor’s state of residence, thereby maximizing the portfolio’s tax efficiency.
- Control over cash flows: A key benefit of bond ladders is the control they provide over cash flows. By selecting bonds with staggered maturities, investors can align their cash flows with future financial needs, such as funding education or retirement. Staggered maturities also allow for proceeds from matured bonds to be reinvested at then-prevailing interest rates. This control is akin to the customization options in direct indexing, where investors can adjust their equity holdings to meet specific financial goals.
- Risk management: Direct indexing often involves adjusting a portfolio to manage specific risks, such as sector or factor exposures or individual security risk. In a bond ladder, investors can similarly manage risks by diversifying across different issuers, sectors, and maturities. This diversification helps to mitigate the impact of interest rate changes, credit events, and economic shifts, potentially providing a more stable return profile.
Bond ladders vs. bond funds and ETFs
Traditional pooled investments such as bond funds or ETFs, whether active or passive, purchase a diversified portfolio of bonds. While these funds offer diversification and professional management, they lack the customization and control that bond ladders provide. In a bond fund or ETF, investors are subject to the decisions of the fund manager, including bond selection, duration management, and the timing of capital gains distributions.
In contrast, a bond ladder allows the client to hold individual bonds, giving them direct control over the portfolio's composition, maturity schedule, and even possible tax outcomes. This direct ownership is analogous to holding individual stocks in a direct indexing equity portfolio, where the investor has complete visibility and control over each security in the portfolio.
Challenges and considerations
While bond ladders have the potential to offer significant advantages in terms of control and customization, they also come with certain challenges. Building a bond ladder requires careful planning and expertise, particularly in selecting bonds that align with the investor's objectives and risk tolerance. Additionally, managing a bond ladder requires ongoing attention to reinvestment decisions and market conditions, which can be time-consuming for individual investors.
Liquidity can also be a concern, especially for bonds with lower credit ratings or those issued by smaller entities. Finding liquidity in municipal bonds can be especially challenging for individual investors. While a bond ladder manager has the tools and resources available to overcome these challenges, investors considering a bond ladder as a form of direct indexing must weigh these factors against the benefits of customization and control.
The bond ladder opportunity
Bond ladder portfolios represent a compelling approach to fixed-income investing that aligns closely with the principles of direct indexing. By allowing investors to customize their bond holdings, control cash flows, and generate tax-efficient income, bond ladders offer many of the same potential benefits as direct indexing in the equity asset class. The ability to create a tailored bond portfolio that may meet specific investment goals makes bond ladders an attractive option for investors seeking personalized fixed-income exposure.
By: Hunter Willis, CFA®, QRG Portfolio Manager
For more information about Envestnet's QPs, which are managed by the company's quantitative asset management unit, QRG Capital Management, Inc., please visit: https://www.envestnet.com/qrg/.
