Tax-efficient investing: separately managed accounts

See how a strategy based on personal preferences might help save on taxes.

Key Takeaways

  • If clients want to own individual stocks, advisors might want to consider separately managed accounts (SMAs) as an option.
  • SMAs offer a high degree of transparency because the advisor can track individual positions and prices intraday and also provide their clients individualized tax management.
  • Unlike mutual funds or exchanged-traded funds (ETFs), SMAs can be customized. For instance, certain sectors or investments can be excluded.

Investment strategy has never been a one-size-fits-all process. When it comes to investing and retirement planning, the strategic use of separately managed accounts (SMAs) is one personalization strategy that advisors are employing with their clients to meet their investing needs.

Constructing a portfolio

Like mutual funds and many ETFs, SMAs are managed by professional asset managers who focus on specific asset classes, such as stocks or bonds. Unlike mutual funds and ETFs, SMAs are portfolios of individual securities that clients own directly as a component of their overall portfolios.

Since SMAs are comprised of individual securities, they offer transparency and allow clients to see exactly what investments are held. ETFs offer some level of transparency, but without the ability to customize the underlying holdings. Mutual funds only report full holdings quarterly, while the value of the SMA holdings is reported daily.

Customizing a portfolio

While advisors construct solid asset allocation strategies for their clients, SMAs provide the ability to create personalized portfolios, actively managed for clients' personal situations and tax status.

A key component of an SMA is that advisors can tweak the holdings to suit clients' personal preferences. For instance, someone might want to avoid a particular industry. If, for example, they already own a generous amount of energy stocks in their overall portfolio, they might decide to limit their exposure to industries related to oil, gas, and consumable fuels so that their overall portfolio isn't too concentrated in those industries.

Further, advisors can customize SMA holdings, removing specific holdings from an account. This is a distinction from mutual funds that don't provide this custom-built management approach.

The value of tax-efficient investing

In addition to the ability to personalize a portfolio, SMAs offer trading and tax efficiencies, which can add to their appeal as an investment vehicle. Depending on the investment strategy of the SMA, a range of personalized tax-efficient investment techniques can be applied in an effort to increase after-tax returns. One popular technique is tax-loss harvesting, a method for reducing how much will be owed in capital gains tax by selling holdings that are losing value and buying a replacement security. This strategy is frequently used to offset taxable realized capital gains in the current or future years. Net result: Less money goes to taxes and more stays invested.

While effective tax-efficient management techniques can be applied to portfolios composed of mutual funds and/or ETFs, SMAs offer advisors more opportunity for tax-loss harvesting because SMAs typically include a large number of individual holdings.

For example, if stock XYZ in a mutual fund or in an ETF suffers a significant loss, clients are not able to sell off stock XYZ from the fund to realize a loss on it. With SMAs, clients own the specific securities allowing the sale of XYZ stock and replacement with a similar security to maintain the appropriate exposure for the strategy. Clients can then use the loss to help offset taxes anticipated on income or realized gains elsewhere in their portfolio.

Understanding how capital gains distributions work

Another tax advantage that comes with SMAs is the ability to avoid specific capital gains distributions, a common concern with mutual funds, and to a lesser degree, ETFs. With a mutual fund or ETF, all shareholders are hit with the tax liability on the capital gains incurred by the fund, which must be distributed annually.

For example, clients purchasing shares of a fund in December will not benefit from any price appreciation the fund has had during the year. However, they may still receive a distribution if the fund has capital gains to distribute and if their purchases are prior to the distribution date. Once received, they will have a tax liability for that year. However, clients invested in SMAs will only have a tax liability when the individual securities are sold. This gives them a more direct link with their capital gains and tax obligations. Clients may also have the ability to fund their SMA with securities they already own, which can help reduce any tax impact as they transition into the portfolio.

What's right for your clients?

Separately managed accounts are not for everyone. But if your clients like owning individual stocks or bonds, and they're looking for a customized portfolio and tax-efficient strategies, it may be worth considering if SMAs can play a role in their investing strategy. As always, it's important to align any investment strategy with personal objectives, financial situations, and risk tolerances.


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