By Blake Lynch, Head of Sales at IMTC.
Predicting the bond market’s next move is difficult at best—will the yield curve steepen or flatten? Will the 10-year yield climb or fall back? Will high yield default rates increase or hold steady? Whatever predictions we might make would be iffy and would quickly become stale. But there are long-term trends in fixed income investing that we can see without a crystal ball or tarot cards because they are already here, under our noses, and growing in importance for fixed income managers everywhere. Here are six trends we are hearing in the industry:
#1 – Direct Indexing or Custom Indexing – Whether you prefer the term direct or custom, it’s a big topic in asset management. While perhaps most familiar in the equity space, building client-specific versions of an index-tracking portfolio has been garnering a great deal of attention in fixed income. If you think it is mostly a marketing gimmick, think again.
We see direct indexing as a progression that started with ETFs that replicate specific segments of the bond market. A fixed income ETF might offer a portion of an investment grade corporate bond index, perhaps defined by a maturity range. Another ETF may strip out CCC-rated and below issues from a high yield index to provide a risk profile that better matches investors’ risk tolerance.
Portfolio managers found that these ETFs can do a good but imperfect job of meeting clients’ needs. That led to direct indexing spread into the SMA space. Active fixed income managers are seeking ways to serve clients in ways that improve on passive index-tracking, at a reasonable cost. Direct indexing is appealing because it allows active managers to use their research skills to construct customized, indexed portfolios for each client at a competitive price. Fixed income ETFs already hold just a subset of all of the bonds in an index; direct indexing improves on that concept and provides tax advantages.
Managers (should) know that broad fixed income ETFs may inadvertently violate clients’ investment policy statements or may have large exposures to one or more names that a client may not like; direct indexing avoids these problems. By tracking a bond index, ETFs tend to own the largest issues in that index (typically weighted by issue size) to minimize tracking error and optimize liquidity. That can unintentionally concentrate exposures in highly indebted companies or in large/mega-cap firms. For high net worth individuals, direct indexing can generate non-trivial tax savings by holding or selling specific bonds at losses to minimize the tax burden to the client.
Creating individualized index-like solutions is only possible because of improvements in technology and data availability (i.e., access to current bond inventories). It is now feasible to customize portfolios at scale, to make them similar to an index but adjusted to meet each client’s preferences. Here’s an analogy: a woodworker who makes chairs entirely by hand cannot produce anywhere near the number of chairs that would be possible with specialized saws, double-ended screws, power tools, and so on. The job requires skill and craftsmanship either way, but having those tools allows the furniture maker to build many more chairs in a given amount of time. In the same way, direct indexing at scale is only possible with the right technology tools and information.
#2 – Increased Use of Home Office Model Portfolios. Financial advisors have limited capacity to both manage clients’ portfolios and grow their business. A solution can be to either (1) hire an internal team to manage portfolios while the advisor markets to new clients and supports existing relationships; or, (2) tap into a home office’s model portfolios. Having a team in a home office that advisors can tap into saves them from having to build or acquire their own tools to do things like tax-loss harvesting or optimizing. Home offices know this is the way for advisors to expand their practice efficiently and are therefore looking to offer these technology-driven solutions. Additionally, it is allowing some firms to bring assets back inhouse instead of outsourcing management. The trend suggests this is a win-win.
#3 – Tax-loss harvesting in SMAs. Growth in SMAs has been substantial in recent years as clients are looking for more customized solutions. This led to managers looking for ways to automate tax-loss harvesting across thousands of taxable accounts that hold municipal bonds (corporates are often held in tax-advantaged accounts). While no technology can replicate the human judgment needed to choose which specific bonds to sell among a group of candidates, technology can quickly and efficiently generate a list of good candidates, such as bonds that are trading below a given loss threshold, so that a human can review them. Algorithms even account for the de minimis rule, which is once again affecting muni investors as many bonds now trade at a discount.
As interest rates have risen, more munis are trading at a discount; therefore, in addition to tax-loss harvesting there are opportunities to convert ordinary income into capital gains by finding Original Issue Discount bonds that are trading at a discount but within the de minimis limit. This may make them more appealing than corporate bonds whose interest payments are taxed as ordinary income (of course, consult with a tax expert before proceeding).
#4 – Truly optimizing rather than sequentially allocating. Determining where bonds can fit across hundreds or even thousands of portfolios can be extremely (and excruciatingly) time- consuming. Allocating bonds in a way that optimizes outcomes across portfolios is frankly impossible without a technology assist. Many firms claim to use an optimizer, but in reality, they rely on a sequential allocation tool. A sequential allocator sees a hole in a portfolio (e.g., a duration that is too long or short or a sector weighting that is off target), finds a bond that satisfies the criteria, then moves on to fill the next hole. While faster than a manual approach, sequential allocation does not construct solutions holistically and just seeks to fill holes.
More fixed income managers are recognizing the value of a true optimizer that looks beyond filling holes and takes a holistic approach. A true optimizer is a decision-support tool that helps firms find actionable solutions much faster than a manual process could, but still blends in the art of bond-picking and overall portfolio management because the manager defines and controls the optimizer’s selection criteria. A robust optimizer allows managers to control the inputs so that solutions comply with each client’s investment policy and can achieve benchmark-driven targets within specified tolerances. Of course, an optimizer must choose from available inventory so that the suggested solutions are viable. Jim Switzer, Head of Fixed Income at AllianceBernstein, recently said, “Fixed income investors need to look at the real-time investable universe (and ask), ‘Is there anything out there that fits our portfolios that we don’t know about?’ An Optimizer is the Holy Grail.” More firms are looking to use a true optimizer but few are available. Learn about IMTC’s offering.
#5 – Insisting on system interoperability and aggregating various data sources. In a nutshell, buyside firms now expect this. They are over the days of exporting files from various systems into Excel, doing VLOOKUPS to match records, and then importing the combined file into their main system. There is significant business risk with that outdated approach, and key man risk because the person who built the spreadsheet could leave the firm. Firms want a single source of truth – one system that shows what they hold in each of their portfolios – so that they can optimally determine which trades to make, and then push those trades to an execution platform. That requires systems to open up and talk to each other. Integrations into other platforms and data sources is an absolute necessity.
#6 – A shift in the Build vs. Buy debate. The idea of building an in-house system that perfectly captures exactly how your firm manages portfolios and conducts trading seems great. Then, reality sets in: the time and cost to build and test, fix bugs, make enhancements, hold onto capable programmers (who want to work on new projects, not system maintenance) and get access to limited in-house IT support. Most firms now look to Build & Partner or Buy & Partner. Either way, firms are partnering with a SaaS vendor that has experienced developers that can embed customized functionality into your system, do validation/QA work to make sure the system does what you need it to do, and if not, customize it further. Some SaaS vendors can even provide cloud hosting so that firms don’t have to devote resources to hosting in-house or manage a cloud vendor relationship that is beyond your expertise.
We believe these six trends are changing fixed income portfolio management for the better. Contact us to learn more about how IMTC’s platform can help your firm to embrace them and grow your business through all market cycles.