By: Investor Solutions, Inc.
While the popularity of Separately Managed accounts has grown over the last several years, so too has the search evolved to find a lower costing investment vehicle that is tax efficient, has low turnover, shows complete transparency, and generates solid returns. Part I of this II part article, focused mainly on the costs associated with Separately Managed Accounts vs. Passive Investment Management and demonstrated the significant drag fees can have on a portfolio over the long haul. In Part II, we will tackle a few other differences between Separately Managed Accounts and a Passive Investment Strategy and determine which portfolio over the long term will provide you the highest return per unit of risk.
One of the main features promoted by those that offer Separately Managed accounts is the manager’s ability to take on tax loss harvesting. Tax loss harvesting is a process of selling securities at a loss to offset any investments sold that incurred a capital gain. At first glance, this is an attractive reason for high net worth individuals to own SMAs and minimize their tax bill each year.
For Example: Throughout this year, an investor sold off outside investments incurring a $10,000 capital gain. The investor, or if he has a good advisor, can look into his separately managed accounts to see if there are any stocks that can be sold at a loss to offset the realized gain. Once the stocks are identified, the request is communicated to the SMA Manager to sell those particular positions at a loss. This is great! You are able to utilize the feature of the SMA and are able to benefit by offsetting at least some of the $10,000 realized gain. This is the easy part.
Where it gets a bit complicated is after the sale. Each SMA Manager has a different policy on tax loss harvesting. Some Managers do not even allow it. They mention that selling off stocks for tax loss harvesting may hurt the performance or the integrity of the portfolio. Ultimately, an investor is paying a premium for a feature and not having the ability to take advantage of the benefit. Some managers will offer the service, sell the stocks at a loss, but leave the money in cash for a month to avoid the 30-day wash-sale rule. This is not a good option if the market goes up and the investor’s money is on the sideline. One approach you have to be careful of is those managers that sell the stocks but then automatically buy and sell small portions of all the other stocks in the portfolio to rebalance the account. Not only does this increase the trading in the account, it may also generate additional capital gains you were not expecting. The good advisors and SMA Managers will continuously look for these opportunities, sell the stocks when necessary, and find alternative investments like ETFs as a holding spot to keep the money invested in the market. Unfortunately, for most investors who own separately managed accounts, the feature of tax loss harvesting is significantly underutilized.
In a Passive Investment Management approach, tax loss harvesting is not nearly as complex and can be much more tax efficient. First, most passively managed structured investments which include index funds and ETFs, generally pay little to no capital gains distributions throughout the year. This is an upfront advantage for those investors with a disciplined long-term approach to investment management. Essentially, you own a large basket of companies, with minimal turnover, inside a single security. A well-diversified portfolio will have a mixture of passively structured investment holdings with low correlation to give you the best return per unit of risk in a very tax efficient fashion. Unless an index fund or ETF is sold within a passively structured investment portfolio, taxes should be minimal from year to year. If at some point capital losses need to be incurred within a passively structured investment portfolio, there is only one transaction to sell the basket of companies at a loss and one transaction to immediately purchase another basket of companies. This is fine as long as the new investment is not substantially identical to the one previously sold for a loss. This can make a well-diversified Passively Structured Investment portfolio more tax efficient, less complex and as mentioned before, purchased at a lower cost.
There are advisors out there that take on tax loss harvesting for their clients faithfully; however, the majority of advisors do not have a formula or a process in place to reap the benefit of this feature. The advantages of separately managed accounts are all wonderful as long as the clients utilize their features and understand their benefits. The reality of separately managed account holders is that only a handful of clients actually need and utilize some of these features. Ultimately, total fees within an investment portfolio along with Uncle Sam dipping his hand into your account, create a significant drag on wealth creation and wealth preservation. Seeking an investment advisor with a philosophy in Passively Structured investment management can virtually eliminate both which will provide you a portfolio with the best return per unit of risk over the long haul. This raises the question, “Are separately managed accounts appropriate for the high net worth segment of the population?” I will end by referring back to a quote from Part I of this article about the issues with Separately Managed Accounts, “Ultimately a client may be paying a premium for an aesthetically appealing account he may not necessarily need.”