The use of direct indexing has historically been considered an equity investing strategy, but as Jonathan Rocafort recently told ThinkAdvisor, that perspective is changing.
Rocafort, Parametric Portfolio Associates' head of fixed income solutions, said that financial advisors with clients nearing retirement will do well to study up on the elements of direct indexing and related techniques that can be deployed on the fixed income side of the portfolio. Building customized and highly tax-aware bond ladders is an especially interesting opportunity, he said.
According to Rocafort — who also wrote a recent blog post on the topic alongside Issac Kuo, Parametric's quantitative research head — the professional advisor community is now relatively well informed about tax-loss harvesting opportunities on the equity side, as well as the growing importance of separately managed accounts. That's one big reason why research groups like Cerulli Associates have published such bullish outlooks for direct indexing and separately managed accounts.
Where more advisors may lack key knowledge is with respect to tax-aware bond investing and the opportunities that are emerging to deliver customized retirement income portfolios at scale. Taking advantage of new sources of investing support in these areas, Rocafort suggested, can help free up time for advisors to focus on the fundamentals of client service while also delivering investment performance.
Direct Indexing Basics
With equity direct indexing, an investor purchases some or all of the stocks in an index to obtain its market beta, often within a separately managed account framework. With this approach, owning individual stocks instead of the actual index (or a similar exchange-traded fund) creates a number of opportunities.
Investors can use tax-loss harvesting to generate tax alpha, Rocafort observed, potentially leading to higher after-tax returns. Investors can also introduce deeper levels of customization not otherwise available in a traditional mutual fund or ETF, by, for example, factoring in clients' beliefs about environmental, social and governance issues directly into the investment oversight process.
This also means that advisors are recognizing related opportunities within the fixed income asset class. Specifically, Rocafort explained, managers can now deliver municipal, corporate or Treasury bond ladders that also follow a customizable, rules-based approach.
"Today, investors and their advisors can work together to build equal-weighted laddered portfolios that can be customized for credit quality, duration, maturity range and other characteristics," Rocafort said. "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."
The result, according to Rocafort, is the efficient delivery of highly customized and responsive portfolios that capture the market beta of a fixed income asset class across the targeted maturity range.
Tax Efficiency and Aligned Values
According to Rocafort and Kuo, taxes are a crucial element in direct indexing, and tax-loss harvesting may actually have added benefits in a fixed income portfolio compared to an equity portfolio. For example, the opportunity to harvest losses in an equity portfolio may effectively run out if no new cash is added and 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," Rocafort pointed out. "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 U.S. Treasurys, corporates and in-state versus out-of-state municipals."
As another example, a traditional municipal bond buyer in a mid-tier tax bracket may benefit from a more tactical but still rules-based approach, Rocafort explained, one that aims to optimize the allocation between tax-exempt and taxable bonds. This can be done based on the client's tax rate and the relative value between sectors, with the manager always buying the bond with the highest after-tax yield.
