It’s all about control of the
A multitude of papers extol the tax virtues of investing through
separately managed accounts. Most have compared them with mutual
funds and have concluded that SMAs can produce better after-tax
returns than funds for those able to take advantage of managing
individual lots of securities.
But what about SMAs in comparison with exchange-traded funds or
with a broker-directed account?
The tax benefit of an SMA most often cited is the ability to
harvest losses. Harvesting losses has been measured to add about
80 basis points of after-tax return annually to an indexed
portfolio. More tax
alpha is produced in the early years, with
little harvesting to do in later years once the portfolio has
become one of mostly unrealized gains.
If an SMA portfolio is held until death so that the step-up in
basis of gains forgives the gains tax, totally efficient after-tax
savings will have been achieved. If the portfolio holds its value
and is sold before death, then any losses harvested will come back
as gains, triggering a tax. Thus loss harvesting can become only a
deferral vehicle. Those now-realized gains may be taxed at a
higher or lower rate than the tax rate that was in effect when the
losses were harvested.
The second benefit ascribed to SMAs is that in a mutual fund,
other investors can cause portfolio transactions that generate
taxable distributable income. These shareholder redemptions can
taxable distributions to holders even if the investor's
holding hasn't changed. Alternatively, changes made to an SMA
portfolio will create taxable events only for the investor.
Because of these two issues, SMAs are perceived as more
tax-efficient than mutual funds. But what about a comparison with
ETFs also are RICs that must pass through other people's gains.
But ETFs have a redemption-in-kind mechanism that allows them to
distribute their big winners to redeeming holders, ridding the
portfolio of unrealized gains. This mechanism should allow a
passive portfolio to distribute few, if any, gains. If the ETF
makes no distributions during the investor's holding period, and
he or she holds it until death, no capital gains tax is ever paid.
Of course, if the ETF holder sells, they will crystalize a gain or
versus their cost basis.
It should be noted that an investor in an SMA pays the management
fee directly to the manager. A management fee expense is a
miscellaneous itemized deduction that is useless to many taxpayers
This is not a problem in either form of RIC — ETFs or mutual funds
— because they are allowed to net their expenses against their
income when calculating how much income they have earned. Thus, in
an SMA, the investor pays tax on phantom income that in a mutual
fund or RIC they would not.
The control of the portfolio's pieces is what gives an SMA its
favorable tax attributes. Not only can an SMA holder harvest
losses but he can also pick which lot of shares are to be
delivered when selling.
SMA holders also can give low-cost-basis shares as gifts, a
benefit not available when the portfolio is taxed as one. If
taxpayers give stock to charity, they can deduct from their taxes
the current market value of the shares. If the shares had
unrealized gains, the gains tax is forgiven.
A broker-directed account can have many of the same favorable tax
attributes as an SMA; it is all about having control of the
portfolio's parts. Loss harvesting, specific lot identification
and giving of low basis shares are all available in both types of
In a RIC or an SMA, investors join in while the game already is in
play. Investors may be buying into a position that's already been
run up, but the manager is waiting for the position to go
long-term. In a broker-directed account, the positions will be
scaled into as the broker advises.
SMAs can have definite tax advantages over mutual funds for those
investors with sizable holdings. Even then, those who cannot take
itemized deductions should take a hard look at the total tax
effect of having such an account. The comparison of SMAs with ETFs
is not quite as favorable and would need to be analyzed on a