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.
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.