Before investing in a
mutual fund, carefully
risks, fees, and
expenses, which are
contained in the
from the fund. Read the
Separately Managed Accounts: Tailored to Suit You
Mutual funds have been one alternative for many investors seeking professional money management. But when you
buy shares of a mutual fund, your assets are pooled with those of other
fund shareholders. You gain professional money management, but the fund's
certainly can't tailor its portfolio to meet your individual requirements.
For investors who want or need a more customized approach — for example,
in order to better manage their tax liability or control individual stock
holdings — separately managed accounts (SMAs) have become popular. Historically
used by institutional investors and high-net-worth individuals, SMAs are
now available to a wider group of investors as an alternative to mutual
funds, though SMAs typically still require a higher minimum investment than
a mutual fund might.
What is an SMA?
An SMA is a personal investment account that is customized and managed
for you by one or more professional money managers. In an SMA, your assets
are not commingled with those of other investors. With a mutual fund,
you buy and sell shares of the fund. Even though each fund share represents
a proportionate ownership of individual securities within the fund, your
share of each of those securities is tiny. By contrast, you are the sole
owner of each security within your separately managed account. You also
may be able to place securities you already own in an SMA; with mutual funds, you
can't. Typically, the account owner has the ability to customize the account by excluding certain securities or industries, or employing tax-advantages vehicles.
Why is that control important? It increases your ability to coordinate
the sale of specific securities with the rest of your overall financial
It was once common for SMA programs to require a minimum of $1 million
in investable assets, but today you can find separately managed accounts
with minimums as low as $50,000. SMAs' lower minimums, along with a growing
appreciation of their unique features, may be reasons for their increasing popularity.
Is an SMA the same thing as a wrap account?
Both wrap accounts and SMAs charge fees based on the size of assets in
the account, and the terms sometimes are used interchangeably. However, with
a wrap account, your financial professional may serve as the account's money
manager, selecting individual securities or mutual funds for your portfolio.
With an SMA, your financial professional may rely on a separate money manager
(or multiple managers) to handle the day-to-day management of the portfolio
or specific components of it. For example, with an SMA, you may be able
to have a money manager who specializes in bonds manage that portion of
the portfolio, while another manager who specializes in stock handles the
equity portion. An SMA must be managed by a registered investment advisor,
who may be independent or part of the same firm as your financial professional.
How SMAs trump mutual funds on taxes
Mutual funds have an inherent lack of tax efficiency. When you buy shares
of a mutual fund, you automatically get a share of its embedded tax liabilities.
By law, mutual funds are required to pay out realized capital gains to all
fund holders, regardless of how long you have held its shares.
if you buy shares in a mutual fund right before a distribution
date, you may receive a distribution and have to pay capital gains taxes
even though you may have held the fund for only a short amount of time.
The lack of tax efficiency can be a greater problem for actively managed
mutual funds that buy and sell securities frequently than it is for
indexed mutual funds.
Also, some fund investors can find themselves owing income tax on their
fund investment, even though the fund may have declined in value during
the year. If a fund manager sells some of a fund's holdings at a profit
but other holdings drop in value, the fund can have a capital gains distribution
even though its overall net asset value is lower.
By contrast, each security held in an SMA has an individual cost basis.
That allows you to make specific tax-motivated moves. For example, you can
generally request that your manager sell a position with an unrealized loss
in order to offset capital gains, thus reducing your income tax liability.
You sold a vacation home at a profit, but do not qualify for
any exclusion. As a result, you owe capital gains taxes on that gain. To
reduce your tax liability, you instruct your SMA manager to sell part of
your position in a stock that has dropped in value. The manager sells enough
stock to ensure that the losses on it offset any capital gains taxes you
would owe as a result of the real estate sale.
How SMAs compare with mutual funds on trading costs, fees, and performance
Unlike traditional brokerage accounts, which are commission-based, SMA
fee structures are asset-based. They typically cover the investment management
fee, trading costs, custody, reporting, and financial planning services.
One thing to consider when comparing mutual fund expenses against SMA
fees is the "invisible" trading costs incurred by mutual funds.
Mutual fund expense ratios cover fund management fees, administrative costs,
and other operating expenses. However, they don't cover trading costs, which
include brokerage commissions whenever the fund buys or sells securities.
Although these trading costs can vary significantly by mutual fund (depending
in large part on their annual turnover rates), estimates of these costs
range on average from 0.5% to 1.5% but can be higher.
Also, mutual funds often carry a certain amount of cash as a cushion
in case they experience a wave of redemptions from investors. That cash
can act as a drag on performance. If a fund has to sell securities to meet
redemption demands, that also can affect its results. Though an SMA involves
its own risks and doesn't automatically guarantee you'll have better returns,
you don't have to worry about the impact of other investors' actions, because
an SMA has no other investors.
Because of the different ways in which fees for mutual funds and separately
managed accounts are calculated, it can be challenging to compare those
fees. Generally speaking, the larger your account, the more likely you are
to benefit from an SMA. Before investing, ask your financial professional
to do an "apples to apples" comparison between SMAs and mutual
funds, including total fees and trading costs, to determine which is the
better deal in terms of overall costs.
How SMAs can be customized for your specific situation
Another important feature of SMAs is their ability to allow you to exclude
certain securities. You also can set sector guidelines to avoid investing
in a sector you might disapprove of (for example, tobacco or casino stocks).
This flexibility allows you to better tailor your asset allocation for your
own unique circumstances and desires — key considerations for many investors
with concentrated stock positions.
You work for a large company that is a mainstay of most large-cap
stock indexes, and you also hold shares in the company as a result of having
exercised stock options. You instruct your SMA's manager not to buy your
company's stock, to prevent your
net worth being too dependent on one company.
However, don't expect to micromanage every single trade, as you might
with a traditional brokerage account. Within the guidelines you set,
the money manager typically will have discretion to implement strategies
that he or she feels will provide the best returns for you. (After
all, if you want to make all the decisions yourself, it probably doesn't
make sense to hire a professional money manager.) However, you still
have flexibility to integrate those decisions with
the rest of your financial concerns. And you'll always be able to track
what has been bought and sold on your behalf.
The bottom line
For investors who place a priority on control and tax efficiency, and
have the necessary capital, an SMA program may make a lot of sense.