Tax-smart investing: Separately managed accounts

See how a strategy based on your personal preferences might help save on taxes.

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Key takeaways

  • Investors should consider the amount of time, energy, and effort they want to devote to managing their investment portfolio.
  • If you want to own individual stocks, but not manage them directly, separately managed accounts (SMAs) might be worth considering.
  • SMAs offer a high degree of transparency because you can track individual positions and prices intraday and can also provide individualized tax management.*
  • Unlike mutual funds or ETFs, SMAs can be customized: You can pick a limited number of investments to exclude.

It seems like everything is becoming personalized today—from DNA testing and cancer treatments—to made-to-order meal plans for weight loss and even designing your own clothes online.

When it comes to investing and retirement planning, the strategic use of separately managed accounts (SMAs) is one personalization strategy that some savvy investors are employing to meet their financial needs.

Constructing a portfolio that can help support an existing investing strategy

Unlike mutual funds and exchanged-traded funds (ETF), SMAs are portfolios of individual securities that investors own directly as a complement to their overall portfolios. Like mutual funds and many ETFs, they're managed by professional asset managers who focus on specific asset classes, such as stocks or bonds.

"I have worked with clients that had a solid asset allocation strategy, but were disheartened by the amount of time they were spending to manage their large portfolio tax-efficiently," said Fidelity vice president, financial consultant, Brandy Mahoney, based in Framingham, Massachusetts. "Once they retired, they realized there were a lot of other ways they wanted to spend their time."

According to Mahoney, one of the appeals of an SMA is the ability to create a personalized portfolio, actively managed for a client's personal situation and tax status. "There's a team of people behind the scenes making trading decisions, which is comforting for many clients," Mahoney explains.

Customizing a portfolio based on personal preferences

A key component of an SMA is that your portfolio manager can tweak the holdings to suit an investor's personal preferences. For instance, someone might want to avoid a particular industry. If they already own a generous amount of energy stocks in their overall portfolio, they might decide to limit their exposure to Oil, Gas & Consumable Fuels, for example, so their overall portfolio isn’t too concentrated in that industry.

You can also elect to remove specific holdings from an account. "Someone might want to buy an SMA but then say, 'pursue this strategy, but make sure I do not own these 3 particular stocks,'" Mahoney said.

Mutual funds, on the other hand, are structured as pooled investments for a large group of investors and can't provide this custom-built management approach. "If you buy a mutual fund, everyone owns the same thing and you cannot exclude specific industries that you prefer not to invest in," she said.

According to Shannon Bouchard, director of managed solutions at Fidelity, SMAs can fit the needs of a customer who enjoys directly owning individual stocks or bonds and having precise, up-to-date information on what they own. "Many investors find managing a sizeable portfolio too time consuming, requiring very specific tools and keeping up with a lot of ongoing investment research," Bouchard said.

Knowing exactly what you own

"SMAs offer transparency and can allow an investor to see exactly what investments are held at any time," Bouchard said. "ETFs offer some level of transparency, but without the ability to customize the underlying holdings or to see exactly how many shares you own. Mutual funds only report holdings quarterly, while the net asset value of all holdings of an SMA is reported at the end of every day."

He added, "The SMA, however, will list each of the positions and values separately, re-price throughout the day, and the total value of the account will be the aggregate value of each of the positions."

The value of tax-smart investing

Depending on the investment strategy of the SMA—most focus on different asset classes of stocks or bonds—investment managers can apply a range of personalized tax-smart investment techniques in an effort to increase after-tax returns.* One popular technique is tax-loss harvesting, a method for reducing how much will be owed in capital gains tax by selling holdings that are losing money and buying a replacement security. This strategy is frequently used to offset taxable realized capital gains in the current or future years. Net result: Less money goes to taxes and more stays invested.

While effective tax management techniques can be applied to portfolios composed of mutual funds and/or ETFs, SMAs offer investment managers more opportunity for tax-loss harvesting because SMAs typically include a larger number of individual holdings. This allows for tax-loss harvesting opportunities depending on a customer's specific situation.

For example, if stock XYZ in a mutual fund or in an ETF suffers a significant loss, a client is not able to sell off stock XYZ from the fund to realize a loss on it. With SMAs, the client owns the specific securities. A portfolio manager that supports the client can systematically identify and sell just XYZ stock to take advantage of the potential tax savings if they have realized gains elsewhere in their portfolio or to offset income. XYZ stock would then be replaced with a similar security to maintain the appropriate exposure for the strategy.

Understanding how capital gains distributions work

Another tax advantage that comes with SMAs is the ability to avoid capital gains distributions, a common concern with mutual funds, and to a lesser degree, ETFs. With a mutual fund or ETF, all shareholders are hit with the tax liability on the capital gains incurred by the fund, which must be distributed annually.

For example, investors purchasing shares of a fund in December will not benefit from any price appreciation the fund has had during the year. However, they may still receive a distribution if the fund has capital gains to distribute and if their purchases are prior to the distribution date. Once received, they will have a tax liability for that year. However, if those same investors bought an SMA, they will only have a potential tax liability when the individual securities they own are sold. This gives them a more direct link with their capital gains and tax obligations. These investors may also have the ability to fund their SMA with securities they already own, which can help minimize any tax impact as they transition into the portfolio.

What's right for you?

Separately managed accounts are not for everyone. But if you like owning individual stocks or bonds, and benefiting from a customized portfolio and personalized tax management, they may be worth considering. As always, it's important to align your strategy with your personal objectives, financial situation, and risk tolerance. Consider working with a financial advisor to determine if SMAs can play a role in your personal investing strategy.

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