Seeking passive market exposure? That’s easy, now you can buy an exchange traded funds (ETF) to track virtually any index. But what if taxes or customization matter to you? A separately managed account (SMA) may be a better option to help you achieve the same objective but with added benefits.
ETFs that track indexes are naturally tax efficient given their low turnover and unique creation/redemption process, which allows them to deliver low cost-basis securities in-kind to accommodate withdrawals. However, ETFs are relatively inflexible; by definition, they must hold all names contained within the specified index at their predefined weights.
SMAs, however, 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 are not 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!1
SMAs allow an investor full control over the underlying securities, which, in addition to boosting tax efficiency, allows the investor to specify their unique exposure preferences. These can include managing around a concentrated position or adding responsible investing criteria.
Concentrated Stock Holdings
Investors with concentrated stock often 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 overlap with your concentrated stock holding.
With an SMA, you are also allowed the freedom to express socially responsible views. A tax-managed SMA can be customized to exclude securities issued by companies that, for example, engage in businesses which conflict with your personal views. And because you own the underlying securities, you can choose to be an active share owner by voting proxies as well as filing shareholder resolutions.
While both ETFs and tax-managed SMAs can provide transparent equity exposure, the structure of SMAs offers tax advantages over ETFs. Additionally, SMAs allow for a range of customization, which can help enhance overall diversification and allow you to express socially responsible views. While smaller accounts may be well served by a simple ETF solution, larger accounts can benefit from a tax-managed SMA.
Our Custom CoreTM portfolios let investors take charge of their passive mandates. Since they’re held as separate accounts, we can customize them to meet client needs. Investors can select from a wide range of benchmarks and then tailor their exposure to incorporate their unique objectives. All taxable Custom Core portfolios can also leverage our industry-leading tax-management strategies.
The Value of Tax Alpha
Parametric’s Custom Core strategies are designed to provide flexible, tax-efficient equity index exposure. “Tax alpha” is how we quantify the value of active tax-management. Here, we explore the two key drivers of tax alpha - the overall market return and cross-sectional stock volatility.
1 Based on Monte-Carlo simulation assuming 6% market return and 35% security volatility. Net of 35 bps management fee. The value add of tax management depends on market environment and is generally higher in years of lower return.
Tax-Managed Custom Core strategies are offered by Parametric Custom Tax-Managed & Centralized Portfolio Management. Non Tax-Managed Custom Core strategies are offered by Parametric Investment & Overlay Strategies. All investments are subject to the risk of loss.
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.