The Benefits of Separately Managed Accounts

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Investment vehicles can provide investors with unique opportunities to access market exposure. A vehicle that has been gaining popularity lately, Separately Managed Accounts (SMAs) enable customization beyond the level provided by Exchange Traded Funds (ETFs), which allow investors to accommodate specific portfolio needs and desires. For this reason, we have incorporated them into our client strategies, where appropriate. Here, we’d like to discuss the benefits of SMAs, which provide greater flexibility, exposure, and tax efficiency than ETFs. [1]

Flexibility in Funding and Implementation

One of the biggest hurdles we see in the ETF vs. SMA realm concerns funding and implementation. Most clients come to their advisor with legacy holdings, which might have been gifted from parents or relatives, or obtained as low-basis stock from a company. Clients usually don’t want to sell the “golden goose” for sentimental reasons.

This creates a predicament when building a balanced portfolio, as these “golden geese” can create significant exposure –and ETFs can only be funded with cash. Thus, the investor might feel forced to sell their legacy holdings to purchase shares of ETFs.

Conversely, an SMA portfolio can be funded with existing cash or securities. This flexibility allows many clients to maintain their legacy holdings while building a portfolio around that exposure. Rather than forcing clients with legacy positions to choose between realizing gains on assets or adhering closely to an advisor’s preferred strategy, the client can now thoughtfully transition to the desired portfolio over time.

In some instances, when an investor possesses a certain amount of concentrated stock, the SMA can be constructed around the position while slowly unwinding the holding in a tax-neutral manner, assuming that the stock is not so concentrated as to represent a prohibitively high portion of the client’s portfolio.

Customization and Control

Like an ETF investor, an SMA investor can choose to track individual benchmarks. However, the SMA investor can further enhance their portfolio by combining different benchmarks to gain the desired exposure.

Source: Balentine

Using the example in the previous section of a client that may have a large, concentrated position in their company’s stock, say within the oil and gas industry. This type of concentrated position can skew the allocation of a client’s portfolio. In a traditional ETF portfolio, we would buy a package of index-weighted exposures, including some in energy, and thus increase the client’s overall balance sheet exposure to the oil and gas industry.

A customized SMA can be structured to exclude this company from the portfolio and can even exclude other stocks in this industry if appropriate to help provide the client with a more balanced overall allocation.

Customization can also be helpful regarding investors’ preferences or values. One example of investor preferences and values is ESG (Environmental,Social, and Governance) investing. While we do not actively promote exclusionary overlays, these strategies remain the most requested ESG offerings among high-net-worth individuals — and we expect the demand for ESG overlays to continue to increase in the coming years. The suite of ETF ESG offerings can be limited, often reflecting what the provider deems important, whereas an SMA allows investors to take control and choose from over 70 screening options. This ensures advisors tailor portfolios specifically to investors' beliefs, not taking off-the-shelf options.

Tax Efficiency

Perhaps the biggest potential benefit of SMAs is their tax-efficient nature. This comes from the ability to use a strategy called tax-loss harvesting and to conduct tax-efficient rebalances. Tax-loss harvesting is a strategy that involves selling securities that are at a loss—“harvesting”—and using those losses to offset capital gains from other securities.

Source: Balentine

We believe tax-loss harvesting isn’t as easily achieved with an index-tracking ETF fund because investors own interests in the fund instead of individual securities. This would cause the investor to have to sell all or part of the ETF and shift into a different but “like” ETF for a minimum of 30 days to avoid regulatory issues. While not a time-consuming exercise, it can create unwanted transaction costs and asset allocation mismatches.

Systematic tax-loss harvesting through an SMA also improves what we call tax alpha. Tax alpha refers to the increase in an investor's after-tax return that results from employing tax-efficient investment strategies. In other words, it is the additional return that an investor can earn by taking advantage of tax-saving opportunities.

Tax alpha is different from market alpha, which refers to the excess return that an investment generates compared to its benchmark. Tax alpha is generated by minimizing the tax impact of an investment, which can result in a higher after-tax return. This can be achieved through strategies such as tax-loss harvesting, which involves selling securities at a loss to offset gains and reduce taxes, or holding investments for longer periods to qualify for lower long-term capital gains tax rates.

The concept of tax alpha is particularly important for high-net-worth individuals, as taxes can have a significant impact on their investment returns. By minimizing the tax impact of their investments, investors can increase their after-tax returns and potentially achieve their financial goals more quickly.

A custom SMA is also market-agnostic, meaning that even in years when the overall index is producing positive returns, many tax-loss harvesting opportunities present themselves.

The below chart shows the S&P 500 individual securities return for the calendar year 2021. Of the 505 constituents of the S&P 500 Index, 61 companies had a negative calendar year return in 2021, while the entire S&P 500 Index returned 28.7% for the year. In this instance, the SMA investor can sell securities that are trading at a loss and utilize the losses to offset gains in other areas of the portfolio. In contrast, the ETF investor is left with no tax-loss harvesting opportunities. This systematic, year-round tax loss harvesting can add +1%-2%in potential after-tax returns.

Source: Bloomberg, Balentine

The other tax benefit of an SMA is when an advisor looks to rebalance the portfolio. For example, if an advisor preferred U.S. Growth stocks but wanted to rotate into U.S. Value stocks with an ETF portfolio, the advisor would have to sell all the growth ETF and buy the value ETF. Depending on the market, this could be a large tax hit.

An SMA facilitates a lower turnover, and, therefore tax bill, by allowing the managers to selectively sell securities to rebalance. This selectivity is driven by the fact that a stock can appear in multiple indices and, therefore, need never be sold. For example, at the time of this writing, Meta, Google, Pepsi, and Home Depot are in the Russell 1000 Growth Index and the Russell 1000 Value Index.

A personalized approach

As the world of finance continues to evolve and innovate, Balentine looks to find solutions for clients that meet their needs, goals, and objectives. SMAs have provided a route to greater flexibility, customization, and tax efficiency. Just as the ETF revolutionized investing many years ago, we believe the SMA represents the next large step forward in the evolution of market access and customization, and we’ve already added SMAs to the menu of options for our clients’ bespoke portfolios.

If you’re curious about how these investment vehicles could be a part of your personal financial plan, one of our relationship managers would be glad to chat with you.

Balentine LLC (“Balentine”) is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Balentine’s investment advisory services can be found in its Form ADV Part 2, which is available upon request. This information has been prepared by Balentine LLC (“Balentine”) and is intended for informational purposes only. This information should not be construed as investment, legal, and/or tax advice. Additionally, this content is not intended as an offer to sell, or a solicitation of any investment product or service. This information is confidential, for one-on-one use, and should not be redistributed to anyone who is not the intended recipient.

[1] For a refresher on ETFs and SMAs, read Innovation in Investment Vehicles.

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