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ETFs or Separately Managed Accounts: Which Are Better?

Martha Strebinger photo

Martha Strebinger, CFA

Investment Strategist (emeritus)

For investors smitten with passive market exposure, there’s lots to love. They can flirt with a bevy of exchange-traded funds (ETFs) that track virtually any index or benchmark.

Admittedly, ETFs have a lot of attractive features—perhaps most important, a high degree of diversification at low cost. But despite the proliferation of ETFs, some investors may still not find exactly what they’re looking for in tax efficiency, benchmark exposure, or ESG criteria, for example. Maybe you’d prefer to specify the percentage of revenue from carbon emissions you want in your portfolio. Or maybe you have a concentrated stock position elsewhere in your holdings and don’t want more of the same sector or industry positions in the ETF.

For these and other reasons, a separately managed account (SMA) may be a better option to help you achieve the same passive-investing objective as an ETF—but with added benefits.

What is a separately managed account?

Like an ETF, an SMA can provide you with an index-based market exposure. The range of indexes available through ETFs is large and includes cap-weighted indexes, such as the S&P 500®, Russell 3000®, and MSCI EAFE indexes, as well as alternatively weighted indexes such as the Research Affiliates Fundamental Index. However, an even broader selection of indexes is available for separate accounts, since not all indexes are available in ETF format—for example, the Russell Defensive Equity indexes. In addition, SMAs can target blended benchmarks, and you can change this blend dynamically over time as your investment views change.

Unlike ETFs, in which the names held are fixed, SMAs can be flexible in their holdings (and still express a low tracking error to the underlying benchmark), which can result in greater tax benefits. Let’s look a bit more closely at this and other reasons to consider an SMA.

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Potential Parametric solution

Greater tax efficiency
ETFs that track indexes are naturally tax efficient given their low turnover and unique creation and redemption process, which allows them to deliver low-cost-basis securities in kind to accommodate withdrawals. But by definition an ETF must hold all names contained within the specified index at their predefined weights.

SMAs, on the other hand, have greater freedom around what names can be held and at what allocations. And this flexibility allows you to capitalize on powerful tax-management techniques, such as gain deferral and security-level tax-loss harvesting, which aren’t possible within the ETF structure.

A tax-managed SMA can be designed to deliver the same diversified index-like exposure as an ETF while offering increased after-tax returns. Our experience and research suggest that this return advantage can be around 1.5% annually on an after-tax, net-of-fee basis for investors facing the highest tax rates.

More control

Unlike ETFs, SMAs give investors full control over the underlying securities, which, in addition to boosting tax efficiency, allows them to specify their unique exposure preferences. These can include managing around a concentrated position or adding factor tilts.

For example, if an ETF investor decides to make a style change from a market-cap-weighted benchmark to a value factor exposure, the embedded gains might be quite significant. With a tax-managed SMA, the investor can more smoothly transition the holdings in existing accounts to the new investment mandate. The SMA manager can identify security positions that overlap between the old and new mandates. Overlapping securities can be held through the transition, avoiding unnecessary tax and transaction costs.

Investors with concentrated stock can buy a diversified ETF. However, buying an ETF that invests in the same stock, industry, and sector as the concentrated stock position can be counterproductive. Using a customized SMA, you can reduce the overlap with your concentrated stock holding.

Responsible investing (ESG)

There are a number of ESG-themed ETFs. But they tend to be one-size-fits-all, with limited insight into what’s actually in them. With an SMA, you have greater freedom to express your socially responsible views. For example, you can choose to include only securities with a certain degree of board diversity. And because you own the underlying securities, you can also choose to be an active shareholder, working to change corporate behavior by voting proxies or filing shareholder resolutions.

The bottom line
ETFs may seem like the ideal long-term passive-investing companion, but before you put a ring on one, make sure you’ve considered the added benefits of an SMA. While both ETFs and SMAs can fill the need for transparent equity exposure, the structure of SMAs offers tax advantages over ETFs, especially for high-net-worth investors in upper tax brackets. SMAs also allow for a range of customization and control, which can help enhance overall diversification and allow you to express socially responsible views. While smaller accounts may be adequately served by a simple ETF solution, larger accounts seeking greater tax efficiency and personalization may find themselves a better match with an SMA.

> Love is all around: Learn more about SMAs and ETFs in our whitepaper.

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.