Thursday, February 13, 2014

SMAs Have Tax Advantages For High-Net-Worth Clients

Rey Santodomingo for writes: Comparing Tax-Managed SMAs vs. ETFs
Advisors using ETFs for index-style exposure in their client accounts should also consider using tax-managed SMAs. While market index ETFs can be a good choice for smaller accounts, or accounts with no need for customization, tax-managed SMAs are often a better solution for larger accounts—providing the same market exposure, but with the added potential benefits of increased tax efficiency and flexibility.

Customizable Index Exposure
ETFs and tax-managed SMAs are similar from exposure and fee perspectives.  However, while available ETFs span market capitalization, investment styles (i.e. value/growth), and geography,  SMA portfolios can be managed to track a wider selection of indexes, including published indexes for which ETFs may not currently be available.  With SMAs, advisors also have the flexibility to customize the index exposure by applying social screens or building a completion portfolio for clients with concentrated positions by excluding certain sectors or industries.

Boosting Tax Efficiency With Loss Harvesting
While ETFs can be tax efficient, SMAs have the potential to be even more tax efficient.  Much of the ETF’s tax efficiency stems from the fact that many ETFs track low turnover indexes -- low turnover usually translates into less realized gains and associated taxes. In comparison, because they are able to take advantage of loss-harvesting opportunities, tax-managed SMA accounts can be even more tax efficient.  Loss harvesting is the systematic process of “selling losers” to realize losses that can be used to offset gains (in or outside of your client’s account) – thereby reducing their overall tax bill.  Since ETFs cannot pass excess losses through to individual shareholders, they cannot provide the benefits of loss harvesting the way SMAs do.

Charitable Gifting
Your client’s tax-managed SMA can be used as a tool for tax-efficient charitable gifting. Within a broadly diversified SMA, highly appreciated positions can be selected for charitable gifts. Gifting highly appreciated tax lots enables clients to fulfill their charitable gifting goals while potentially reducing their current and future tax liability. Since ETFs do not provide access to underlying positions they cannot be used for this purpose.

Tax Efficient Rebalancing And Transitions
The structure of SMAs also creates the potential for cost savings during portfolio rebalances and investment style changes. By allowing access to individual securities and tax lots within the SMA structure, the potential for tax efficiency is greater than with a comparable ETF.  Investors using ETFs may also choose specific tax lots, but only at the ETF level—not at the individual company level.

Both ETFs and tax-managed SMAs provide transparent market index equity exposure. SMAs offer benefits not available with ETFs including loss harvesting, charitable gifting of highly appreciated securities, and tax-efficient rebalancing and transitions. While smaller accounts may be well-served by a simple ETF solution, larger accounts should seek to gain the additional benefits available by implementing their market index exposure through a tax-managed SMA.
The author Rey Santodomingo is a member of the Investment Strategy team at Parametrics.