Occam’s – When Does a Separately Managed Account Make Sense?

Mass customization is the dream for most industries, and the financial services industry is no different. Everyone’s investing goals are different, so it makes sense that we would want to be able to specifically design the funds that we use to reach our goals. The plethora of mutual funds and ETFs out there give us a lot of flexibility (there are significantly more mutual funds and ETFs in the US than stocks) and allows most people, in most situations, to get where they want to go – but they can’t cover everything. There will be situations that just can’t be addressed by general mutual funds and ETFs. This is where Direct Indexing and Separately Managed Accounts (SMAs) come in.

Separately managed accounts are just what they sound like. They are investment accounts that are managed separately – they are accounts managed for a specific person or institution. You can think of them as a mutual fund with only one client. And because they are specifically managed for you, you can (usually) customize the strategy and implementation to your specifications. The sky really is the limit; you can probably find someone willing to manage pretty much anything that you can come up with.

Direct Indexing is a specific implementation of an SMA. Whereas an SMA is your own personal mutual fund, Direct Indexing is your own personal index fund. You can still customize the account the way that you want (Direct Indexing is just a marketing term after all), but you’re just starting with an index as the base of the account. The term Direct Indexing is relatively new, but tracking an index with an SMA is nothing new. At McLean, we’ve been managing them for clients for over 10 years.

So why do most people use mutual funds and ETFs that are designed for general groups of people when we can customize solutions? Well, for two reasons: mutual funds and ETFs allow for a lot of customization at the total portfolio level, and SMAs are very expensive.

Most people are able to build portfolios that work perfectly for themselves with “generic” funds. They use traditional mutual funds and ETFs as the building blocks that they are. Think about it like building a house. The builder doesn’t hand hew every piece of lumber, or custom cut every piece of glass. No. There are standard sizes of lumber and windows. You can take these standardized pieces and put them together in the way that benefits you. It’s only in those very rare circumstances where the standardized approaches don’t work, that you go the customized route.

And the reason that everyone tries to avoid custom work is: the cost. And in the investing world the cost is twofold:

• SMAs are more expensive than mutual funds and ETFs
• SMAs that track indices are very likely to see higher tracking error than a mutual fund or ETF tracking the same index.

The reason that separately managed account are more expensive than mutual funds and ETFs is pretty simple – economies of scale. Mutual funds and ETFs pool the money of many investors, while an SMA only has one investor. As a point of comparison, as of August 31, 2021, the Vanguard Total Stock Market Index Fund (VTSAX) had roughly $1.3 Trillion of assets under management. I don’t know about you, but personally I can’t allocate that much to just one asset class.

Now VTSAX is one of the largest funds in the world, and you don’t need quite that many assets to spread the load a little bit, but any reasonably sized fund is going to have a significant cost advantage.

And this doesn’t just show up in the expense ratios that you see. Because SMAs tend to have a smaller asset base than a comparable mutual fund or ETF, their trades are going to be smaller. This means that typically an SMA is going to get (significantly) worse execution than other market participants – especially when you consider that SMA trades are likely to be firmly on the retail side in terms of size. This means higher trading costs across the board, and trading costs aren’t included in expense ratios. They are silent costs above and beyond the stated expenses.

Watch Out For Tracking Error

Beyond the direct monetary costs, SMAs attempting to track an index (whether they bill themselves as Direct Indexing or not) are very likely to have higher levels of tracking error than a mutual fund or ETF tracking the same index. And just like with the costs, the reason for this is the size of the fund.

When you are tracking an index, you want to get exactly the return of the index. Any deviation, whether up or down, is a bad thing (though I’d prefer it if the screw up landed on the higher return side). It’s harder than it sounds to manage this perfectly, but any reasonably large mutual fund or ETF can do a decent job, because they can go out and buy all of the stocks in the index in their appropriate weights[1].

Generally, SMAs do not have anywhere close to enough assets to do this. They use an approach called sampling, which is pretty self explanatory. Because they can’t simply buy everything in the index, the SMA will go out and buy a subset of the names in the index designed to try and replicate the returns of the total index. Usually this subset is based on a number of factors, and some approaches do a reasonably good job of getting close to the returns of the index – but it’s still luck of the draw. If your sampling approach happened to pick the wrong company that you’ve never heard of, that could easily lead to a pretty spectacular tracking error – and lead to your returns looking pretty different than how they should have been.

The Benefits of SMAs

But it’s not all doom and gloom. SMAs can play a valuable role in a portfolio. But they are just another tool in the toolbox. There are certain jobs that SMAs are great at, and there are many where they don’t make sense. So, what advantages do SMAs have? Well, SMAs shine in two specific situations:

• When you want or need very specific customizations in your portfolio
• When you are very concerned about tax management

Going back to the home building analogy, most of the time you can make use of off the shelf parts and get exactly what you want, but sometimes you just can’t. Sometimes you really do need that custom made part. And that’s where SMAs come in. Because they are custom to you, you can pretty much do what you want (within reason).

Own What You Want

This often comes up around ESG investing[2]. ESG investing is very personal, and there are just as many approaches as there are people interested in it. While there are certain buckets that most people tend to fall into, not everyone fits neatly into those buckets. Sometimes the differences are a minor annoyance, and going the SMA route won’t be worth it (for all of the reasons we’ve discussed). But sometimes, if you can’t find a set of funds that work for you, and you’re willing to shoulder the costs, an SMA can be a great solution. You can specifically design the portfolio you want and get very granular in how your portfolio is constructed.

You could also be looking to manage the specific risks that you are facing. A lot of this comes down to strategy selection, but there are times that you might want to get extremely specific. For instance, say you get a good chunk of your compensation from work in the form of company stock. You may want to avoid investing any more in the company you work for, and even limit your exposure to the industry you work in because you already have a high level of exposure to that risk.

Another very common reason to use an SMA is to manage around a big holding that you have in your portfolio for one reason or another. Whether it’s in there because you started the company, or your aunt gave you a few shares of Apple for your birthday back in the early 80’s, it can wreak havoc on your asset allocation. Knowing that, you can design your SMA around the position. Going back to the sampling approach we discussed earlier, you can wrap the holding into the broader strategy and try to pull things back into place based on the other stocks that the SMA buys. Alternatively, an SMA is a great tool to help you get out of a concentrated position by managing the amount of capital gains that you have each year. This brings us to the other strength of an SMA – Tax Management.

Manage Your Tax Bill

Tax management is probably the most common reason that someone would decide to use an SMA. Because the account is yours, it can focus specifically on your personal situation. You don’t need to worry about how it will affect anyone else’s taxes, or whether it aligns with their goals. It’s important to note here that if you are using an SMA for tax management your goal isn’t necessarily going to be maximizing the returns of the account, or even maximizing the after tax returns of the account. Generally you’re going to be focused on maximizing your after tax wealth across the entirety of your financial situation.

Aside from the basics like trying to minimize short term capital gains and maximizing the qualified portion of the dividends that you receive (which a lot of mutual funds and ETFs do as well), SMAs allow for some personalized tax management strategies like Tax Loss (or Gain) Harvesting. Whether this is done to help ease the transition out of that concentrated position we just talked about or “just” to reduce your capital gains bill, this can be a powerful strategy. Especially when you consider that because the SMA is dealing with individual securities, there will almost always be some stocks that are doing well, while others won’t be doing so well. Even in years where the markets are going up, it’s very likely that at least some of the stocks in the SMA will have gone down. All you have to do is harvest that loss and then put that money back into another company in the index (remember, you’re probably sampling, so you can just slot another company in and likely have almost the same overall exposure).

But tax loss harvesting isn’t free money, and you can only do it for so long in any particular portfolio (unless you’re regularly adding more money). We actually like the reason for this. Over time markets tend to go up. That’s great for us as retirement focused investors, but it does mean that the longer we have an investment, the less likely we are to have a loss that we can harvest. This is a great problem to have, but it does mean that unless you are periodically adding money to your SMA you won’t have many opportunities to harvest losses in your account. Depending on the strategy (and how nice the markets are feeling), this process will take a few years, but it’s important to note that there is a clock on this strategy.

Also, tax loss harvesting does not mean that the capital gains you are offsetting go away. It’s better to think about it as delaying gains (and the corresponding taxes). From a mechanical standpoint, when you harvest a loss you are selling a security with a high cost basis and then buying a security with a lower cost basis. You’ve essentially just pushed those gains out into the future when you will sell the security that you just bought (assuming you don’t pass it on to your heirs and the get a step up in cost basis). In addition to simply pushing the gains out into the future, you’re also pushing those gains out into a future tax regime, which may have higher or lower taxes on capital gains.

This is not to say that tax loss harvesting is pointless. It’s a great tool – it allows you to help manage the amount of taxes you pay over time, and there’s always the time value of money to consider. Simply put, a dollar today is worth more than a dollar tomorrow. You just need to know when tax loss harvesting makes sense to use.

In fact, there are circumstances where you want to go the other way and harvest gains. And an SMA is able to handle this just as easily as harvesting losses. An interesting example of this is a client situation we had a few years back. There was a client who was moving from a low tax state to a relatively higher tax state. They wanted to take advantage of the lower tax rate prior to their move, so we harvested as many gains as possible, and then rolled the proceeds into an SMA that was tasked with harvesting losses once the client was living in the higher tax state. By accelerating their gains to ensure the lower tax rate, and both minimizing and delaying their gains at the higher tax rate, they were able to reduce the tax bill they would otherwise have had to pay.

If you are charitably inclined, SMAs also open up an interesting opportunity – gifting appreciated holdings. Many non-profits are set up to allow you to donate securities (and if your gift is big enough the rest of them will definitely figure out how to make it work), and they generally do not need to pay taxes on capital gains. This means that if you donate your holdings with the highest gains in place of simply writing a check to an organization, you not only get the tax deduction for the donation you are making, you also clear some of the accumulated gains out of your portfolio that you would otherwise have had to pay taxes on.

Like all tools, SMAs (whether they are billed as Direct Indexing or not) have their time and place. There are always tradeoffs involved, but SMAs allow for levels of customization and tax management that mutual funds and ETFs are simply not set up to provide. The question is whether those benefits are worth the increased costs, both implicit and explicit, that come with an SMA.

---

[1] Note that I’m talking about stocks here. Bond indices often have huge numbers of issues included, and many of those are very thinly traded, which often means that bond index funds aren’t necessarily able to hold all of the names in the index.

[2] ESG stands for Environment, Social, and Governance. ESG Investing seeks to invest based on a set of philosophical beliefs. It is sometimes known as Social Responsive or Impact Investing as well.

---