Close Close

Financial Planning > Tax Planning > Tax Loss Harvesting

Fulfilling the SMA Promise

Your article was successfully shared with the contacts you provided.

Based on recent media coverage and conversations with financial advisors around the country regarding separately managed accounts (SMAs), it’s clear that the SMA players have done an excellent job marketing these products and pushing their benefits. Probably every self-respecting advisor knows the purported benefits of SMAs: tax efficiency, customization, tax control, risk control, and simplified reporting.

But what most advisors may not realize is that only approximately 12% of taxable separate accounts actually receive some kind of tax treatment, according to Cerulli Associates Inc, and industry estimates show that only 24% of accounts benefit from tax customization. This is due to the fact that the industry has neither technology nor the manpower to deliver on the promise that was made when the account was sold. This is particularly painful for high-net-worth investors since tax is their single largest obstacle to long-term growth. To understand the solution for these investors, we need to take a closer look at the underlying inadequacies in the SMA industry.

Customization vs. Scalability

The SMA business has frequently boasted about the advantages of using a separate account structure over pooled vehicles claiming customization and tax management as its winning combination. In reality the SMA industry has come to mirror the mutual fund world in many ways and the promise of customization and tax management, in most cases, has not been delivered upon. Why?

From the manager’s perspective mutual funds are far more attractive to manage due to the fact that their structure eliminates customization or tax management at the individual client level. As a result the margins on running funds are substantially higher than those on separate accounts.

For decades the industry has utilized separately managed accounts, but until the 1980s reserved this vehicle primarily for large institutional clients. With the advent of the wrap account, the structure was introduced to the high-net-worth investor in the late ’80s on a mass scale, however, the popularity of the vehicle was limited due to the initially high investment minimums. With the introduction of “mass customization,” otherwise known as the “models approach,” minimums fell precipitously and assets under management began to grow.

Using this technique the manger simply created one “ideal” model and mandated that all accounts they managed conform to it. Although each client owns individual securities, their account does not differ from the thousands of other accounts under management in the strategy at the firm. The AIMR compliant returns posted by every separate account manager in the business bears this out. In this report, the manager states assets under management, performance, benchmark performance and dispersion for each of their products. Dispersion simply states the difference in performance from the best to the worst-performing accounts. (Ask your favorite SMA manager to see their AIMR report to see for yourself.)

This SMA methodology was introduced primarily to benefit the nontaxable institutional investor whose sole concern was and is investment performance. Firms with low dispersion could assure these institutions that the performance was consistent among their accounts and that the institution would get what the manager had advertised. Firms strived for low dispersion. Unfortunately, this demand for consistency flew in the face of what the SMA industry had promised the high-net-worth community. Customization and tax management at the individual client level would most certainly lead to high dispersion. The SMA managers had essentially created a mutual fund with a lot of different account numbers.

Customization and tax management also led to scale problems that the SMA industry could not handle operationally. A simple example of the challenge faced by a manager would be to look at two hypothetical clients. Client A invested with an SMA Manager in January 2007, who at that point purchased 10 shares of IBM for $10 per share on the investor’s behalf. One year later, client B invests with the same manager who still owns IBM which is now worth $6 dollars per share. If the manager harvests the $4 loss for client A, two issues arise:

1. What should be purchased with the proceeds from this sale?

2. Who is responsible for making sure that IBM isn’t repurchased within 31 days?

If the manager does in fact conduct this trade, now client A’s and client B’s accounts are different and cannot be traded in bulk. The dispersion will increase. This problem compounds exponentially as the number of accounts and positions owned grows.

The Overlay Solution

In the past five years advances in technology have brought the idea of alpha, tax management and customization back together in the SMA industry in the form of the overlay manager. The solution’s roots date back almost 100 years to Henry Ford and his assembly line. His revolutionary idea was to have workers specialize in a certain aspect of the construction of a car. This focus approach allowed them to master their specific craft and allowed Ford to turn cars out at a frenetic pace.

With the SMA business the solution is identical – separate the process into its component parts: alpha generation or stock selection and tax management/customization or trading and allow each entity to master its craft. The concept is quite simple: allow the stock pickers to pick stocks and identify a trading manager to execute on these ideas with an eye to tax. The concept has further matured by allowing the investor to combine multiple managers into one account and allowing the overlay manager to trade them all simultaneously.

Early on, overlay managers faced the same challenge of scale as the SMA business. The recent development of batch order trading systems, smart technology and quantitative trading tools tailored to the taxable client is making it possible to deliver customization at the individual level for the mass market. Today, the client of an overlay manager can designate the investment managers they want to use, the capital gains tax budget they are willing to realize annually and the restrictions that they want in place at the security level.

Additionally, if the client is changing strategies or advisors, they can dictate the level of realized capital gains taken in transition. Gone are the days when tax management was relegated to tax loss selling in the last days of December. As the market moves, beneficial tax trades can be made daily on the individual client level. With overlay management, the industry’s focus on simply beating a benchmark has shifted to providing the client the best absolute return (investment – fees and taxes) possible.


© 2023 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.