The first Forbes article from Jonathan Rogers, co-managing partner for Forum Financial Management and a contributor of the Forbes Finance Council, discusses separately managed accounts. Read the article below.
The Skinny on Separately Managed Accounts
Many investors with over $1 million to invest have been sold on the idea of separately managed accounts (SMA) by private wealth advisers. It is an enticing story. Separately managed accounts directly hold stocks and bonds that are yours and yours alone, and they can minimize capital gains. These benefits sound like the perfect solution for independently wealthy clientele. The problem is, when you fact-check the sales pitches of Wall Street, you often discover they operate on partial truths. Here is the other side of the story.
Sales Pitch 1: You hold the actual securities.
The marketing of the first private wealth group I came across using Google led with a statement saying that you directly own the individual securities. Of course, they say this like it is a good thing. To be fully diversified, you should invest in several hundred, if not several thousand, securities. That becomes an operational nightmare in SMAs, so they deflect by stating a limitation in jargon that our minds rationalize as a good thing.
This same manager goes on by touting how their deep bench of economists start with a top-down view of the economy, implying that they can choose which countries, industries and even companies might be the best investments. I will not belabor it here, but there are myriad academic papers showing how active managers have consistently failed to outperform with some derivative of that strategy for decades. The 2013 study by Elton, Gruber, and Blake looked specifically at SMAs and reached the same conclusion: that they do not outperform the major indexes.
Then there are the managers who argue you only need 30 securities to be properly diversified. To truly maximize diversification, a portfolio should hold dozens of securities in each industry, because any individual security will not reliably deliver the return of its entire industry. It should also hold very small companies, very large companies and those in between. However, even that is not enough, because that same breadth needs to be replicated across countries in both developed and emerging markets. By my count, that would take more than 30 securities.
Often, if pressed, these managers will email some research, such as that produced by Fisher and Lorie back in the 1970s, showing the standard deviation of a 32-stock portfolio is approximately equivalent to the standard deviation of the market. This one falls into the category of strategic ignorance. They either don’t understand that standard deviation alone is a poor measure of risk, or they are trying to deceive you by throwing numbers at you. The portfolio volatility in a year may be similar to the market, but over several decades a set of random 32-stock portfolios will have wildly different final outcomes.
Sales Pitch 2: Mutual funds generate gains.
The second most common argument is that mutual funds realize capital gains even when you personally do not transact. How terrible! But why do they realize these gains? It is because the mutual fund managers are rebalancing the individual securities within the fund. You want that kind of realized gains.
What you want to avoid is unnecessary trading, or, in industry jargon, high turnover. However, some mutual funds like those from The Vanguard Group (Vanguard) or Dimensional Fund Advisors (DFA) have average turnover below 10% within their mutual funds. That amount turnover is very healthy, as it is necessary simply to stay invested in the right proportion of each security.
This same balance between turnover and capital gains holds equally true in SMAs. The only way they can achieve lower gains is by not trading. But not trading quickly leads to a portfolio becoming over-concentrated in the securities that have done well and underexposed to those that have done poorly. This is a major caveat to separate account managers’ argument for tax efficiency, because, too often, they willingly sacrifice the long-term return for the short-term tax savings.
A related argument is that you should not buy into unrealized gains inside mutual funds. This is a slightly more nuanced argument. It goes like this: if a fund turns over 10% and it has built-in unrealized gains of 50%, then you could expect a capital gain distribution of roughly 5% over the next year, even though you just invested. While basically true, its actual effect is smaller than you might expect. Re-investing the capital gain dividend into the most underweight asset class both pushes the next rebalance further into the future and creates a high basis tax lot available to sell the next time they rebalance. The result is the total tax incurred typically equalizes as early as the next rebalancing event.
Sales Pitch 3: Avoid the impact of irrational investors in the fund.
The tide of retail investors running into and out of mutual funds can create havoc. Again, this is true if only from a narrow point of view. All investors should be cautious of investing in mutual funds that hold very few securities or predominantly illiquid assets. However, going back to our previous examples of DFA and Vanguard, their funds are massively diversified, so they have hundreds of securities to choose from when raising cash for redemptions. Furthermore, both of these fund managers had consistent positive cash flows even during the years 2008 and 2009, when many mutual fund and separate account managers had net outflows.
Now that we have debunked the most common sales pitches on the street, it begs the question, when does it make sense to invest in an SMA? Luckily the answer is straightforward: if you already have one and the tax realization is unjustifiable. The specific recommendation for whether to get out or bite your lip varies based on your personal tax situation, but a rule of thumb I use is, if you are over 85, then the unrealized gains need to be more than a third of the account value. If you are over 55, the gains need to be more than half. Otherwise be skeptical of anyone trying to sell you on the benefits of a separately managed account.
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