Principal partners with YieldX, Smartleaf on fixed-income direct indexing

Principal Asset Management is hoping to bring direct indexing, already one of the fastest-growing trends in equity investing, to the fixed-income space.

Just as advisors can use direct or custom indexing to build a customized managed account of individual equities, rather than using an ETF or mutual fund, Principal’s latest addition to its model portfolio solutions lets advisors do the same with individual bonds.

The new offering was created in partnership with fixed-income fintech YieldX and direct indexing provider Smartleaf Asset Management. Principal also has a partnership with risk analytics fintech Jacobi Inc. to help advisors understand how model portfolios will behave in different market conditions.

Principal started working with Smartleaf in May to launch a new digital portal that lets advisors tweak the holdings in a model portfolio with direct indexing, but the addition of YieldX to do the same with bonds is a first for the industry, said Jill Brown, managing director of Principal’s U.S. wealth platform. Now advisers can offer any combination of mutual funds, ETFs, individual equities and individual bonds through a model portfolio available through a single digital portal.

“We feel we are definitely leading with what we are building with YieldX and Smartleaf,” Brown said. “We really see how coupling [asset management] with technology could help us not only continue to grow our assets, but use technology to free up time for advisors.”

While only 12% of financial advisors are currently using direct indexing, Cerulli Associates anticipates its growth will outpace that of mutual funds, ETFs and separately managed accounts over the next five years.

Other direct indexing products have avoided the fixed-income space because it has a different liquidity profile and requires going directly to dealers, YieldX CEO Adam Green said. It’s a complex asset class to understand, and there are a seemingly endless number of products that could be right for an investor.

YieldX’s technology simplifies access to bonds and can help advisors tailor the fixed-income portion to a client’s needs and goals more than a traditional wrapped product allows, Green said. While building a custom index of fixed-income securities can provide some of the same tax-loss harvesting opportunities as equities, the primary benefit is on customization.

“There is nothing like this out there,” Green said. “What we’re trying to do is accrue those net benefits of how tech can open up a market to the end investor.”

However, Chuck Failla, founder and CEO of Sovereign Financial Group, said tax-loss harvesting would be one of the main benefits of using a separately managed account consisting of individual bonds rather than a fixed-income mutual fund. For example, when the value of a bond goes down because of an increase in interest rates, advisers can do a bond swap and realize a tax loss.

While lower quality, high-yielding bonds are probably better in a packaged fund, direct indexing can help advisers do these swaps with higher quality bonds, Failla said, adding that he is actively exploring how to add fixed-income direct indexing into his practice.

While it is still in the early phases compared to direct indexing for equities, Failla thinks it can evolve into something “quite useful” for advisors.

“There is no shortage of fixed-income SMAs out there, but what [Principal, YieldX and Smartleaf] are doing is creating a factor-based, algorithmic way of determining which bonds should go into those portfolios,” Failla said.

While Sovereign will likely create its own solution, Principal’s approach could be a great fit for advisory firms without in-house trading capabilities, especially given how Principal and Smartleaf are integrating fixed income and direct indexing into a single offering, he said.

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