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Tax-efficient, customizable investments? Try a private portfolio

  • At the end of 2016, $4.6 trillion was invested in separately managed accounts, up $61.7 billion over 2015.
  • SMAs are useful for investors looking to avoid or focus on certain types of investments for religious or social reasons, as well as those with large positions in company stocks.
  • Technology has made it possible for SMAs to accommodate smaller investors, thanks to improved record-keeping and lower fees.

SMAs let investors closely monitor portfolios and exercise control over types of securities bought.
Michail Petrov 96 | Getty Images
SMAs let investors closely monitor portfolios and exercise control over types of securities bought.

While mutual funds and exchange-traded funds offer convenience, they have drawbacks, including lack of customization and transparency. And some are downright tax-inefficient. Investors who crave a more personalized approach but still want professional management might want to consider separately managed accounts.

"Mutual funds are great, but you could say the same about penicillin," said certified financial planner Jim Lorenzen of The Independent Financial Group. "It's a miracle drug, but some people are allergic."

Separately managed accounts are private portfolios overseen by professional money managers. Though an SMA manager may manage money for a large number of investors, unlike a mutual funds, the funds are not commingled. That allows investors to closely monitor their individual portfolios and exercise control over the types of securities their manager buys.

Since 2013, assets in SMAs have grown steadily, reports research firm Cerulli Associates. At the end of 2016, there was $4.6 trillion invested in SMAs, $61.7 billion more than the year before.

"A client is getting institutional level service at a retail level," said Fatima Iqbal, financial planner and senior investment strategist with Azzad Asset Management.

Azzad's clients are mostly Muslims who want to exclude the types of businesses that Islam prohibits, such as those that make a profit from tobacco, gambling or pornography. The firm has two mutual funds — a large cap blend offering and a bond fund — that do this kind of screening. But other strategies such as small cap growth and international are not available in the mutual fund format. To achieve diversification, Azzad uses the separately managed accounts to find appropriate investments in the different investment styles.

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Similarly, Sheryl Rowling, a CPA and CFP and founder of Rowling & Associates, has used SMAs in the past when clients insist on socially responsible investments.

"Each investor is going to have a different definition of what they view as a socially conscious investment," Rowling said. "You might have one investor that doesn't want to invest in tobacco stocks or military stocks, and then you might have another that wants to invest according to religious values."

Likewise, SMAs are useful for clients who have large positions in company stock. SMA managers can avoid duplication of that stock, or even sector, to ensure diversification. But mutual funds, even those dedicated to a particular strategy or sector, aren't able to accommodate the unique investment needs of an individual investor.

Tax efficiency is key

Though many mutual funds strive to be tax-efficient, there's no way for a fund manager to customize the tax liability for each shareholder. All shareholders participate in the same tax situation. Mutual funds, for example, are required to pass on their capital gains to all shareholders, even those who only recently started investing and didn't participate in the gains.

But SMA managers only pass on capital gains on gains they actually realize because investors own the stocks directly. As a result, managers are able to choose which lots to sell in order to minimize taxes or engage in tax loss harvesting.

"The tax efficiency can be very important," said Iqbal at Azzad Asset Management. "Individual stock ownership means that the manager has more control over capital gains of the clients."

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Rowling has used SMAs to minimize the tax hit when clients come over from another advisory firm with built-up gains in their holdings. Instead of having to sell off all of their positions in order to start fresh with her firm, which can result in capital gains, a client's existing securities can be plugged into the new portfolio, said Rowling of Rowling & Associates.

"If we sell those stocks and the client has to pay all that gain and a mutual fund that owns a lot of the same stocks, that's kind of unfair," she said.

Minimums have come down

In recent years technological innovations have made it possible for SMAs to accommodate smaller investors, because they are able to provide record-keeping even for smaller balances. Even so, many SMA programs have minimums that are well in excess of what you might find in a mutual fund.

For example, Fidelity's Tax Managed U.S. Equity Index Strategy and the Equity Income Strategy each require $200,000 to get in. The strategies charge 0.20 percent to 0.65 percent and 0.30 percent to 0.90 percent, respectively.

"I like to use SMAs for parts of the market that aren't widely followed, because I think that's where a manager can add value." -Jim Lorenzen, financial planner at The Independent Financial Group

To create a diversified portfolio, investors need a significant amount of overall assets, said Lorenzen of The Independent Financial Group.

"I like to use SMAs for parts of the market that aren't widely followed, because I think that's where a manager can add value," Lorenzen said. "But the catch-22 is that it's difficult to allocate enough dollars to those strategies because of the minimums."

For that reason, SMAs are still largely the purview of high-net-worth investors. Advisors said they rarely recommend SMAs for portfolios of less than $500,000.

Other ways to get the job done

Some advisors, such as Scott Bishop, CFP/CPA and partner with STA Wealth Management, have moved away from SMAs in recent years. The explosion of narrowly targeted ETFs makes it possible to provide a high degree of customization for most clients. His firm has started managing investments in house and has developed an investment staff to oversee the portfolios. He is able to charge less all together than his clients were previously paying for SMAs.

"We've created our own models with ETFs, then we do the tactical management," Bishop said.

What's more, Bishop said managing the funds in house makes rebalancing easier. "Rebalancing with SMAs was a real pain," he said. "You could have a large-cap growth manager and a large-cap value manager that would have overlap, or one manager was buying one stock while another was selling it, so a lot of times we ended up not rebalancing."

— By Ilana Polyak, special to CNBC.com

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