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Introduced in 1993 with the launch of the SPDR S&P 500 trust, exchange-traded funds quickly became a Wall Street darling. These newcomers took the benefits of mutual funds to the next level by offering investors index exposure — spanning the S&P 500, MSCI World Index, Russell 1000 and more — and a high degree of diversification at low cost. As such, their ascent was nothing short of meteoric, translating to what is now a $5.3 trillion global market (of which U.S. assets account for some $3.7 trillion).

Another investment vehicle that has been attracting increased interest in recent years is the separately managed account (SMA). Comprising a mixture of securities that are overseen by an asset manager, they are similar to ETFs in that they can provide investors with diversified exposure to key indexes and benchmarks. However, SMAs are differentiated in that their holdings can be flexible, tax-optimized and personalized — all while still maintaining a low tracking error to the underlying benchmark. These appealing characteristics have seen SMA assets swell by an astounding 84% since 2010, according to Morgan Stanley.

In the meantime, another trend has burst onto the scene: sustainable investing. The growing interest in this space has precipitated the rollout of numerous ETFs that incorporate environmental, social and governance (ESG) mandates.

Said ETFs have attracted some $1.3 billion in new assets so far this year, but do these “off-the-shelf” products represent the best way to invest for impact? Let’s take a look at how they stack up against SMAs.

Alignment With Values

ETFs: Despite their various benefits, ETFs can be somewhat limiting when it comes to investing in accordance with one’s values. Many ESG-themed ETFs offer a one-size-fits-all approach, with limited transparency as to what’s beneath the hood. And, given the deeply subjective nature of ethical issues, this rigidity can prove problematic.

Most investors simply don’t have time to examine their portfolios, and subsequently the plethora of relevant ESG data, to determine whether the holdings therein reflect their values. They are dependent on the issuer’s assertion that the fund is, for example, “green,” or LGBTQ-friendly. And often, even ETFs that market themselves as “sustainable” utilize such sweeping and disparate selection criteria that investors may find their portfolios include companies whose business practices undermine their views — whether it’s energy conglomerates such as Exxon Mobil Corp., tobacco companies such as Philip Morris International, the data scandal-riddled Facebook, or others.

SMAs: SMAs are ideal for values-based investing as they allow investors to actively screen for certain product areas (e.g. oil, tobacco), or “bad actors” that they deem antithetical to their values. They also allow for more specificity, e.g. designating a certain percentage of revenue from carbon emissions to be included in one’s portfolio.

Furthermore, because SMA investors directly own the underlying securities, they can opt to play an active shareholder role, working to impact corporate behavior through voting proxies or shareholder resolutions.

Tax Efficiency

ETFs: In some cases, an ETF will distribute capital gains to shareholders. This is not always desirable, as the shareholders are then responsible for paying the capital gains tax.

ETFs, being bundled investments, do not offer tax loss harvesting benefits. Additionally, they can only be funded with cash — which means if an investor is holding securities of another ETF, they will need to sell and purchase with cash.

SMAs: SMAs allow investors to sell stocks at a loss, reducing their aggregate capital gains and subsequently a portion of their taxable income — otherwise known as tax loss harvesting. Because an SMA contains individual securities, capital gains can be offset by selling investments that will produce a capital loss.

Investors are often won over by the ability to fund SMAs with securities and perform tax transitions that minimize tax bills. And who can blame them?

Cost

ETFs often have attractively low operating expenses, in part because most are passively managed. In addition, many issuers have been slashing expense ratios to lure investors. That’s especially appealing for those wishing to align their portfolios with their convictions, since values-based ETFs — sometimes intended as replacements for core exposure — tend to be pricier than their non-ESG counterparts.

SMAs’ fee schedules vary from manager to manager, but are typically higher than those for ETFs. It’s also worth noting that the fee schedules are generally greater for actively traded SMAs that are trying to exceed benchmark performance, as opposed to passive SMAs that are aiming to tightly track the underlying benchmark.

Diversification

ETFs are often lauded for the diversification they offer investors. However, just because an ETF contains more than one underlying position doesn’t mean that it’s immune to volatility — this will largely depend on the scope of the fund. An ETF that tracks a broad market index such as the S&P 500, for example, is likely to experience less volatility than an ETF that tracks a specific industry or sector. However, that relative stability might be offset by a lack of exposure to mid- and small-cap companies that offer growth potential.

SMAs can be helpful when investors find themselves with large concentrated positions in a certain company’s stock, and therefore lacking diversification. A customized SMA enables investors to exclude company stock they already own, reducing concentration risk.

Transparency & Control

ETFs: Actively managed ETFs must publicly disclose holdings daily, though it’s worth noting that most ETFs do so regardless.

That said, even though the individual holdings are made publicly available, it’s very hard for the average investor to review them without the use of sophisticated tools. Few have the time to meticulously comb through this information, much less — as previously mentioned — to cross-reference it with data pertaining to a company’s environmental, social and governance practices.

SMAs enable advisors and clients to view actual holdings at any given time. They are also privy to full details regarding management and account-level fees, and usually receive quarterly performance reports.

Investors have complete control over the underlying holdings, which allows them to specify their unique preferences in terms of concentration, factor tilting, exclusions or the integration of sustainable investment mandates.

Who Are These Investment Vehicles Best Suited For?

ETFs often attract “smaller,” cost-conscious investors that have tax-exempt accounts with no customization needs.

SMAs, on the other hand, tend to represent a compelling choice for more established investors, who are considered at least moderately high-net-worth (i.e. with a minimum of $100,000 to invest), and want to manage the tax liability associated with their higher tax brackets. Often these investors have a more complex portfolio and enjoy a more “hands-on” approach to their investments.

ETFs and SMAs present different value propositions dependent on your clients’ individual mandates and preferences, and it’s important to explore these in detail before making any recommendations. As with all investment products, decisions should be made on a case-by-case, client-by-client basis. When assessing ETF or SMA options for their clients, financial advisors would do well to seek out asset managers that have deep experience in the area, as well as adequate resources and a strong commitment to servicing their specific needs.

Johny Mair is co-founder & chief product officer at Ethic, a tech-enabled asset manager that powers the automated creation of sustainable investing portfolios. Before launching Ethic with his partners in 2015, he spent more than a decade building technology products at Deutsche Bank, JPMorgan and other investment banks across three different continents.