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SMAs over ETFs: Investments That Fit Like a Bespoke Suit

Published on

May 31, 2019

Separately managed accounts (SMAs) can match exchange-traded fund (ETFs) performance with distinct advantages: customization and tax management.

While both SMAs and ETFs can track virtually any index or benchmark, providing a high degree of diversification at a low cost, SMAs surpass ETFs on customization and tax treatment. As an investment adviser, these benefits permit you to improve clients’ after-tax returns without significantly increased effort or risk, and more closely match their investment portfolio to the causes they care about most.

Bespoke investments tailored to each client

ETFs act as a one-size-fits-all vehicle, but not all of your investors are the same. SMAs allow for more customization for each investor, including an increased ability to invest according to specific ethical desires, and a range of modified indexes. ETFs hold the same predetermined basket of securities for every investor. SMAs, on the other hand, give advisers the ability to express each individual’s views.

For example, an individual investor may be simultaneously concerned about climate change and want to avoid Facebook stock due to its recent privacy violations. She will have trouble finding an ETF that both prioritizes climate change and eschews Facebook’s stock– but she can easily achieve this goal through an SMA, with minimal tracking error to the benchmark.

Another investor may want to hold securities with a diverse board of directors. While he may be unable to find this specific basket in an ETF, he can create one with an SMA. Because an SMA investor actually owns the specific security, he can act to change the company’s behavior, through voting in the annual shareholder meeting. The same is not true of ETF investors, since it’s the ETF provider– not the investor in the ETF– who owns the underlying assets. Additionally, this board-diversity-seeking investor’s priorities are likely to be different from someone else’s, so even an ETF that prioritizes diversity might not fit all of his values, definition, or needs, and certainly won’t fit everyone’s.

While the range of indexes available through ETFs is impressively large, the range for an SMA is even larger. An SMA investor can mimic the level of risk of an ETF, with added flexibility if they desire, including alteration for existing holdings.

While this flexibility can benefit your clients in many ways, it’s especially valuable for those who want to limit their exposure to a specific sector. An investor who works at a publicly listed company may already have stock options from their employer. Investing in an ETF would force them to hold additional exposure in their employer, an overweight that isn’t financially ideal. An SMA, however, allows for a more precise targeting of both overweighted and excluded securities, providing that client with better diversification than with an off-the-shelf ETF.

Conversely, for investors keen on more exposure to a certain region or sector– Emerging Markets indexes or the Industrials sector, for example– SMAs provide a simple way to gain that exposure in a passively-managed investment vehicle.

Smart tax management without the lawyers

Tax-managed SMAs let investors experience the same index-like exposure as an ETF while employing tax management techniques like tax-loss harvesting and gain deferral that are much more difficult with ETFs.

Let’s say one of your investors wants to transition from a capitalization-weighted index to a value factor strategy. Transferring from an ETF would require the investor to sell their ETF shares (a taxable event) and purchase the relevant securities. An SMA, however, would permit you to hold any overlapping securities through the transition, avoiding the relevant transition costs and taxes, and optimizing for tax-advantaged strategies like capital gains.

While both ETFs and SMAs can fill the need for transparent equity exposure, SMAs offer significant advantages, especially for high-net-worth investors in upper tax brackets. Additionally, SMAs allow you to create bespoke strategies that can increasingly satisfy your clients and form stronger adviser-client relationships.

Investment in securities involves the risk of loss. Past performance is no guarantee of future returns. One cannot invest directly in an Index. Any opinions, estimates and forecasts offered in this document constitute judgment as of the date of the materials and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information contained in this document to be reliable but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only and it is not intended to provide and should not be relied on for investment, accounting, legal or tax advice. OpenInvest may not have verified (and disclaims any obligation to verify) the accuracy or completeness of any information herein that has been provided or obtained by third parties.

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