Personalized Managed Accounts: Life is easier when batteries ARE included

Why make things harder than they should be? Things should work as advertised, but too often that is not the case. I recently wrote about the disappointment we felt when as children we opened up our new toy and realized it didn’t work. Because the batteries weren’t included. This is much like the traditional Separately Managed Account (SMA) which can be missing the following parts, crucial to saving you time and implementation frustration:

1. Simplicity

The SMA is promoted as a great option for high net worth accounts: you own the underlying securities, it’s customizable, it can be managed for taxes. It appears to solve many needs and wants. However, it isn’t always what it’s made out to be—it comes with work. Often times, a lot of it. 

Most of the benefits of an SMA versus a typical alternative such as a mutual fund require manual work. Manual work = manual labor. Who truly enjoys that? What else could an advisor be doing with that time? And most importantly, if manual work is required, can it be done as well as if it was automated and professionally implemented?

2. The ability to build around investor preferences

What is the alternative then, if going the SMA path for a high-net-worth account requires a lot of time and effort? There are options—quite a few of them, actually. But that is the next challenge: how to decide what actually works best and fits best for clients with different wants and different needs. Some clients may have employment or regulatory restrictions on what can be owned in their personal portfolios. Others may have personal preferences on what they want to and—often more importantly—don’t want to own.  Taxes are often a consideration, but since no two investors are alike, different tax circumstances may need to be addressed. Lastly, if you as an advisor have numerous such clients in your practice, how do you handle all of this customization and make sure that each portfolio is being given first-class treatment?

3. Client-level customization

Many clients want and/or need a level of customization that mutual funds just can’t offer. They may have a security or industry restriction due to employment or regulatory requirements. Or they may have a desire to embrace a preference screen such as environmental, social and governance (ESG) criteria or socially responsible investing (SRI). Or their need could be as simple as an exclusionary restriction of a single security for a whole host of reasons. Eliminating a stock is easy for most advisors who use SMAs, while restricting several securities or a whole industry is a bit more difficult, and implementing a screen is harder still, albeit doable. But that’s usually where it stops. 

Proper customization should answer some key questions. What is the impact of the restriction, exclusion or screen? And how should it be implemented so that the portfolio continues to perform as intended with minimal deviation?

4. Advanced tax management

Many tax sensitive clients need a higher level of tax management. This could come in the form of wanting and needing to limit the amount of taxable income generated by a portfolio each year. Or it could be the need to aggressively tax-loss harvest to offset investment gains generated elsewhere in a total household account. Moreover, the tax management needs to be done throughout the year and goes beyond harvesting losses in Q4.

5. Personalized transition management

Transitioning accounts and holdings shouldn’t be hard, shouldn’t be excessively costly and shouldn’t be a hurdle or roadblock—yet too often it is. Legacy securities and portfolios oftentimes need to be built around and transitioned out of (partially or fully) over a period of time. Transition lengths can vary depending on both investor needs and impact thresholds (or to put it more bluntly, pain thresholds). 

Don’t despair if your traditional SMAs are missing parts

Let’s make the decision about what might work best for different clients a little easier. The table below lays out a number of the most common options available, plus one new one that may actually help you, as well as your clients, breathe easier and achieve better outcomes. I am talking about Personalized Managed Accounts (PMA) by Russell Investments.

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SMA chart

Note: ESG investing is the consideration of environmental, social and corporate governance. SRI is socially responsible investing.

Let’s take a deeper dive into this table. The columns are the most frequently used investment solutions by investors. The rows are features investors may want or need.  This includes customization abilities as well as tax-management options for taxable portfolios.

Traditional mutual funds

They have been around a long time, bringing institutional asset management to Main Street. Mutual funds have been and are a good solution for a great many investors. They are simple to trade, provide liquidity and are easy to use and hold. There are drawbacks, however. For starters, there is no customization with mutual funds. If you purchased one in a taxable account (non-qualified in industry jargon), there is almost no ability to do tax management. And in a taxable account, you may get hit with a surprisingly large tax bill coming from income, dividends and capital gain distributions. Additionally, the holdings are all held within the pooled mutual fund structure, meaning that an investor cannot see what is in it on any given day. Also, it isn’t possible to have access to the underlying holdings.

While the traditional mutual fund is often used by investors across their portfolios, it is arguably most suitable for use in qualified accounts such as individual retirement accounts (IRAs), 401Ks, 403Bs, etc., where taxes are not an immediate consideration and the need for customization is generally low or not possible.

Traditional SMAs

The SMA we know today has been around for about 40 years and has allowed investors with a little more money in their accounts to access both institutional asset management and do so while having some control over their accounts and access to the underlying securities. This has been the appeal of SMAs as control and accessibility is something desired by many investors, as well as advisors.

But there are drawbacks as well with traditional SMAs, as outlined above, starting with the amount of work it may take to do tax management or any customization on the part of the advisor. In addition, the client bears the burden of risk, and the impact on performance  of any deviations in the portfolio from what the asset manager creates (this includes issues like security restrictions, any selling due to tax management, etc). Lastly, while many investors believe an SMA is more tax efficient (and some tax management can be done), the cost due to taxes may be much higher than expected, and there is only so much that can be done to manage the tax bite.

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Annual tax drag per approach

Performance quoted represents past performance and should not be viewed as a guarantee of future results. The investment return and principal value of an investment will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Current to the most recent month-end performance data may be obtained by visiting
Morningstar Categories included: US Large Blend. See appendix at end of presentation for methodology.  Average of Morningstars Tax Cost Ratio for universes as defined. Passive is defined as being an index fund as reported by Morningstar or part of an ETF Category
Separate Accounts: Backtested results. Using Russell Investments database of historical manager holdings, we calculate what tax drag would have been generated by investing each managers portfolio over this period and then calculate the average tax drag across all managers for a given year. In total, 157 managers were included in the study to include managers from US. Tax drag from capital gains is calculated using a short-term tax rate of 43.4% and long-term tax rate of 23.8%. Benchmark returns refer to the average benchmark return across all managers for that year, reported in total returns in USD.

Tax-managed mutual funds

While these are mutual funds similar to those listed above, there is one really big difference. These funds are built to manage the tax impacts on behalf of the investors (the shareholders) and in most cases minimize taxable distributions and tax drag (the amount of return lost to taxes). While a traditional mutual fund may be best suited for an IRA or other type of qualified account, tax-managed mutual funds are built specifically for use in investors’ taxable accounts.

While there are many positives to using a tax-managed mutual fund, there are a few drawbacks such as with a traditional mutual fund. While these funds address taxes, there still is no ability to customize them for an investor’s specific needs. Securities are held within the pooled structure, so an investor cannot access them. And while these are built to be considerably more tax efficient than most other options, the tax management is done within the fund. If an investor wanted to use, for example, harvested losses to offset a portion of income to lower their overall tax bill, they could not do it.

Tax-managed mutual funds can be a really a good solution for taxable investors. But if an investor has needs that go above and beyond what a tax-managed mutual fund can offer, then PMA might be the solution.

Personalized Managed Accounts (PMA): This is the next evolutionary step for investors to take control of their holdings while simplifying and streamlining their portfolio.  Almost everything listed in the table above can be done within PMA. This includes advanced tax management, customization for personal needs as well as personal wants, transition management as you move an existing account or holdings into PMA, right on down to transparency into the portfolio’s holdings and trading activity. And on top of this, PMA offers ease of use in that once you define the parameters, the rest is taken care of by your trusted partners at Russell Investments.

Things work better when we do it together

Mutual funds are a good option for most clients when tax management and customization aren’t needed. Tax-managed mutual funds step it up for clients with non-qualified assets where taxes are an important consideration. Separately managed accounts can be a great option for a lot of clients with specific needs. Using one to meet those needs shouldn’t be as hard as it’s been. Through partnership, the customization desired can be more effectively and more seamlessly accomplished. 

With Personalized Managed Accounts, a higher level of customization can be accomplished, tax management can be implemented frequently and seamlessly and an improved outcome to meet an investor’s goals can be targeted, adding up to more time available for you to focus on building stronger relationships with your clients.