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Bond Funds vs. SMAs: Which Are Right for Your Client?

Who is this for?

For General Public Use.

Key takeaways

  Bond funds and SMAs each have pros and cons.

  Bond investments are very different from stocks; this is especially true in the way they are traded and how indexes are constructed.

  SMAs offer many benefits for investors but tend to carry higher minimum investments.

What Is an SMA? 

An SMA is a separately managed account, defined by the SEC as an advisory account that is not a pooled investment vehicle, like a mutual fund. Pooled or commingled funds combine the assets of multiple investors into a single vehicle, which the investors own a share of. With SMAs, the investor directly owns the securities (like stocks or bonds) in his or her SMA. Because of the private, individualize nature of SMAs, they typically require greater investment minimums than pooled vehicles.

Why Might Bond Investors Want to Use an SMA? 

Generally, SMAs give the investor greater control and transparency, while also offering the ability to customize in some cases. Institutional investors like large pension funds use separate accounts for these reasons.  

Bond investors stand to benefit from SMAs in unique ways. Most stocks are traded in public markets with massive liquidity, meaning there's almost always a buyer when you want to sell, and vice versa. Bond trading, however, is much different. Once bonds are issued, they trade "over the counter" in secondary markets—that is, buyers and sellers must find one another. In practice, this typically means large players making deals. The process begins with an investment bank or other large financial institution acting as a market maker, letting buyers know about bonds for sale.  

Whereas stocks trade frequently and stock markets provide instant pricing, secondary bond market transactions are lumpy and infrequent. For example, although bonds far outnumber stocks, the daily trading volume for stocks was about 10 times that for bonds in 2020 through October, according to SIFMA Research.1 Less trading means bond pricing lacks transparency, and larger block sizes (and larger players) tend to get both better bond selection and better pricing. It's those large asset managers who tend to offer bond SMAs, although naturally the same managers also offer funds.

Understanding Bond Indexes 

With bond funds, again it's useful to consider differences with stocks. Stock funds typically start with an index, which is either tracked closely (in the case of passive funds) or used as a benchmark (with active funds). Most indexes weight stocks based on company size, so the larger a company grows, the larger its weighting in the index and more of it an investor owns.  

Bond indexes and the strategies that use them are different due to differences between stocks and bonds. While there are about 5,000 publicly traded U.S. stocks, the number of individual corporate bonds is a multiple of that, in part because each company may issue dozens of bonds. Similarly, while all investors can own a company's shares, they can't all own part of every bond issued by every company. Instead, bond indexes approximate the total market by matching its composition in terms of issuers, sectors, duration, credit quality, and other factors.  

The result—especially with passive funds—typically means holding more of the most-indebted issuers or sectors, which is probably not the way most people would prefer to invest.

How Do Bond SMAs Compare to Funds? .

Still, bond funds boast a number of pros over other vehicles. Their commingled nature typically leads to lower investment minimums, for example. Also, because of their size, they typically hold a much higher number of bonds than an SMA, which adds diversification and lowers the investor's exposure to each issuer. Additionally, a fund manager can utilize more opportunistic segments of the market that may be higher yielding, but less liquid given the larger scale of a fund.

Even more powerful is the fact that active bond fund managers often use derivatives—like swaps and options—to nimbly gain exposure to opportunities and to more effectively manage risks.  

Passive strategies are typically lauded for being more tax efficient, however SMAs gain an upper hand in this area for their ability to sell securities at a loss and replace with similar ones, a strategy known as tax-loss harvesting. SMAs also tend to manage risk by holding bonds of higher credit quality. While funds tend to be more benchmark-aware and therefore invest more broadly, 

SMAs can be more selective about holdings. Again, this is because SMAs are typically offered by large managers who are able to trade more efficiently and who bring massive resources to bear in the areas of research and trading personnel.  

SMAs can also provide investors with some customization. A municipal bond SMA may strive to hold bonds issued by an investor's state, county, or even city, in some cases reducing state or local taxes owed to those entities (all muni bonds are free from federal taxes).

If you are interested in investing in a fixed-income SMA, visit our Select Fixed-Income Portfolios.  

References

1 https://www.sifma.org/resources/research/us-fixed-income-trading-volume/
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