Today, there is a growing demand for professional fiduciary financial management services through the mechanism of separately managed accounts, especially from wealthy investors. Individual investors that are considered “wealthy” compared to the average middle-income retail investor, are increasingly using Separately Managed Accounts (SMAs) to obtain personalized professional capital management services and tax benefits. DarcMatter has chosen to juxtapose SMAs with the well-known, traditional mutual fund, in hopes to provide further context and a better understanding of the nuances of an SMA.
A Separately Managed Account (SMA) is a portfolio of assets managed by a professional investment firm, as defined by Investopedia. There are two types of SMAs: single and multiple. Although investment minimums vary among asset managers, and $100,000 is a typical low threshold, a single style SMA may allow investors in with as little as $50,000 for equity portfolios and $100,000 for fixed-income portfolios. These SMAs are structured with a distinct style of investing in mind. A multiple style SMA may be suitable if you want to invest in a diverse investment style, because this type represents a diversified portfolio with investments across different asset classes and even among different managers, although one manager oversees all the investments. The minimum investment typically is $100,000 to $300,000. Creating a single style SMA, provides a diversified portfolio that helps avoid the securities overlap and overly concentrated positions that often occur when you combine investment styles without the benefit of a multiple style SMA. Though SMAs are similar to both retail and institutional investment product vehicles in that they are composed of stocks, bonds, cash or other individual securities managed professionally, there are a few key differentiating characteristics.
Mutual funds, for example, allow small investors to pool capital in a professionally managed portfolio and share in the returns or losses proportionately to their contributions. These funds apply an overarching capital allocation strategy for the entire fund, applicable to all investors identically. SMAs have the advantage of a more detailed approach that is specifically tailored to the goals of the investor. In other words, while mutual funds make decisions on behalf of everybody who invested, SMA managers can essentially make decisions on your behalf for the portfolio at the individual level. In this way, SMAs provide mass customization; they offer a package of individually selected financial solutions by the professional but still allow the investor to feel that they are more closely aware of the decisions regarding their account. For example, SMA investors can choose to impose a restriction on “sin” stocks. This is possible because the investor is the direct owner of the purchased securities, a fundamental differentiator for managed accounts, and can adjust the composition of the portfolio together with the manager. Therefore, even if a mutual fund and SMA were to have the same exact composition of assets, allocated with identical weightings, an SMA allows the flexibility to modify even a single position in its holdings if desired. This is a portfolio management benefit that mutual funds cannot offer due to the nature of the vehicle’s purpose and mandate to administer the same investment strategy to all its investors. Both provide professional money management services, but SMAs do not require the pooling of capital with others.
Another key characteristic for SMAs is the minimum required investment amount. SMAs, for which the usual minimum is $100,000, are available mostly to wealthy investors and are offered by Registered Investment Advisors (RIAs), who operate under the regulatory auspices of the Investment Advisors Act of 1940 and the purview of the U.S. Securities and Exchange Commission (SEC). A large amount for opening a managed account is not so much a manifestation of elitism as a consequence of economic necessity. Portfolio managers experience serious difficulties when they try to diversify funds in the amount of less than $100,000 due to issues with capital distribution and high transaction fees.
Personalization also means a high level of tax efficiency, problem that mutual fund managers often face in achieving. Unlike mutual funds, where capital gains/losses are passed on to all investors, an SMA investor is only taxed on realized gains in his or her specific portfolio. Because an SMA contains individual securities, capital gains can be offset through a method called tax-loss harvesting.
When it comes to fee structure for managers, mutual funds benefit from increased transparency compared to SMAs. Though most SMA manager fees are quite acceptable, their basic fee structure is listed in a regulatory filing called a Form ADV Part 2. In most cases, the fees depend on the size of the assets under management (AUM), and the percentage usually decreases as assets increase.
If, however, an investor decided to invest in an SMA, he or she should be very prudent about choosing a good investment advisor. Since the manager in this case receives the fiduciary authority to manage the account of a particular client, both parties must make sure of his “professional suitability” in order to avoid erroneous decisions. Because SMAs do not issue registered prospectuses, investors and/or their advisors need to rely on other sources for investigating and evaluating the manager and conduct thorough due diligence. According to experts, the collection and approval of all documents required to open SMA usually takes several days; in the end, by the time the money really begins to “work,” the market situation may change significantly. This process is much faster with mutual funds.
Nevertheless, experts note that investments in SMA and mutual funds are not mutually exclusive. Mutual funds and SMAs can complement each other and function together as part of a common investment solution for a client who does not have to limit himself to a hard choice. In particular, if an investor buys such types of securities in an effort to achieve higher diversification in this class of assets, participation in a mutual fund may turn out to be more profitable than SMA.