With the Biden administration’s pledge to raise capital gains and income taxes for high earners, implementing customized tax-efficient investment strategies has become a more significant — and urgent — opportunity for RIAs to add value for their clients. In fact, tax efficiency has been one of RIAs’ most commonly cited issues, including during Capital Group’s recent RIA Advisory Board meetings.

RIAs generally are well-versed in using tax-advantaged qualified retirement accounts and tax-efficient asset classes such as municipal bonds to decrease the tax drag on their clients’ portfolios. But other decisions can have a meaningful impact, perhaps none more powerful than investment vehicle selection. Many RIAs use separately managed accounts (SMAs) to provide enhanced tax efficiency and customization for their clients; the SMA market now has more than $1.7 trillion under management.¹ But before moving money from mutual funds and exchange-traded funds (ETFs) into SMAs, advisors should carefully consider their pros and cons and base the decision on each client’s unique goals and financial situation.

Potential tax benefits of SMAs

The primary difference with SMAs relative to pooled funds is that clients own the individual underlying securities in an SMA rather than owning shares in a basket of securities. Owning the underlying securities provides increased flexibility and transparency, which RIAs can use to pursue techniques to reduce tax drag.

Tax advantages of owning the underlying securities via an SMA include:
 

• Tax-loss harvesting: SMAs provide more opportunities for tax-loss harvesting because you can sell individual securities; with a mutual fund or ETF, your only option is to sell a share of the entire vehicle. With an SMA, securities that have declined in value can be sold and replaced with new, similar securities to maintain the targeted exposure for the strategy. The goal is to manage the SMA in a way that doesn’t negatively affect performance goals while also producing excess realized losses.
  
  
• Using existing positions to enter a strategy: SMAs allow you to transfer existing holdings into a strategy rather than having to sell holdings and recognize capital gains. This can be particularly helpful when investors want to fund a new investment strategy or make a style shift — for example, decreasing exposure to growth equities in favor of value equities. In an ETF or mutual fund, a shift in preferred style exposure would require selling shares in a basket of securities to fund new investments. With an SMA, however, investors can more easily move existing holdings to the new investment strategy and avoid unnecessary gain recognition.
  
  
• Capital gains recognition: SMAs also give investors more control over the recognition of capital gains. Mutual funds and ETFs are required to distribute capital gains each year based on the fund’s purchases/sales of securities, which creates a tax liability for investors, even ones who purchased the shares near the end of the year and didn’t benefit from the appreciation over the full 12 months. With an SMA, however, investors only realize a tax liability when the individual securities they own are sold.
  
  
• Charitable giving: SMAs can help investors achieve tax-efficient charitable giving. Because investors own the underlying securities in an SMA, highly appreciated securities can be gifted to a charity or nonprofit to reduce tax liabilities and fulfill charitable goals.

There are several other benefits of SMAs, particularly related to the customizability they offer. Investors seeking to align their capital with their beliefs or principles, for example, may create a custom environmental, social and governance (ESG) strategy by choosing to avoid specific securities or industries or by increasing exposure to investments aligned with sustainability trends. RIAs also can use SMAs to limit a client’s concentration in a particular industry or sector. This can be particularly helpful for investors who have accumulated large positions of their company’s stock or otherwise want to avoid overexposure to their employer’s sector.

Drawbacks of SMAs include relatively high minimum investments and the fact that they can be labor intensive to manage. SMAs are most often outsourced to professional managers who execute the investment strategy. But even when an external manager is involved, advisors must play a hands-on role to make the most of SMAs for their clients — in fact, this effort by the advisor is essential for realizing the tax efficiency and customization benefits for clients.

Active versus passive SMAs

Many of the opportunities to capitalize on the potential tax efficiency benefits of SMAs will depend on whether an SMA is used to execute an active or passive strategy. RIAs need to understand the differences in terms of priorities and opportunities for the manager to add tax alpha between active and passive SMAs.

Passive SMAs are typically used to implement a direct indexing strategy. In this scenario, a manager reconstructs an index at the security level in an individual’s portfolio rather than buying an ETF or mutual fund. Through direct indexing, investors use SMAs to invest passively, but with more control and enhanced opportunities for tax-loss harvesting and other forms of tax efficiency. This strategy is gaining in popularity, but it is important to determine whether the tax gains justify the costs relative to a traditional passive vehicle.

Actively managed SMAs can be used to access the same strategy and management as a mutual fund, but with the control and transparency benefits that come with owning the underlying securities. When considering actively managed SMAs, it is important to realize that the manager’s top priority is generating investment alpha; tax efficiency is likely a secondary concern. Despite this concern, actively managed SMAs still offer opportunities to execute the strategy in a more tax-efficient way, although the responsibility may fall to the RIA to ensure the best approach for their clients.

RIAs need to be in the driver’s seat on the road to tax efficiency

The choice between an SMA or a pooled vehicle should be based on each client’s unique goals and financial situation. Taxes are certainly an important consideration, but don’t let the tax tail wag the dog. The overall goal should be to maximize the amount that the client gets to keep, not just the amount of taxes saved.

Whether using a passive or actively managed SMA, harnessing the potential tax benefits of SMAs requires that the advisor is directly involved. Only the advisor has complete visibility into the client’s goals, tax situation and overall portfolio, so they must communicate these priorities to the SMA manager to ensure alignment with the client’s overall situation. Strong communication — with both your client and your SMA manager — can help you as an RIA enhance their tax alpha and get the most out of SMAs.