Mutual Funds vs Separately Managed Accounts

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Updated:  September 1, 2015

Separately Managed Accounts (SMAs) are all the rage in the investment business. Investment managers, brokers and investment advisors originally positioned SMAs as direct access to “top” portfolio managers for the most affluent. Now, the same investment organizations actively promote SMAs for a much larger group of investors. You might reasonably ask whether investing in SMAs could be wise for you.

Sensible Financial’s view is:

Let’s look at definitions of SMAs and mutual funds, concluding with a table that contrasts them.

A mutual fund is (legally) an investment management company, owned by its shareholders. The shareholders hire an advisor (such as Fidelity, Vanguard, or T Rowe Price, to name but a few) to select the securities that the mutual fund will own. Mutual funds and their advisors are heavily regulated by the SEC, and must follow an important set of rules, most of which are contained in the Investment Act of 1940 (the ’40 Act). These rules have to do with treating shareholders fairly, disclosing certain kinds of costs, etc.

Mutual funds have been the investment vehicle of choice for most individual investors since the mid-1970s. There are significant investment and practical advantages to the mutual fund structure.

An SMA is an individual investment account, managed for you by a portfolio manager1. In fact, that “managed for you” part is what makes SMAs so emotionally attractive to the individual investor. Who wouldn’t want a “top-flight portfolio manager” picking investments just for them? In fact, mutual fund investors do have such portfolio managers working for them. By and large, the companies and the portfolio managers managing SMAs are the same ones managing mutual funds. They use the same strategies and pick the same investments, by and large, as they do for mutual funds. There is no evidence that mutual fund portfolio managers outperform the relevant market indices, and no evidence or reason to believe that SMA managers do any better by tailoring SMA portfolios. In fact, SMA managers would prefer to do as little tailoring of individual SMAs following a particular strategy as possible – tailoring is expensive, and reduces their profits!

Let’s talk directly about the elephant in the room, the recent mutual fund scandal. How can Sensible Financial even mention the oversight of the SEC and the ’40 Act’s benefits to mutual fund investors in light of the recent revelations? The short answer: in the case of mutual funds, there is an SEC available (even if hardly ready) to punish the offenders under the standards of the ’40 Act. For SMAs, there is no set of standards, and the restrictions on portfolio manager and investment company behavior are much fewer. Given the sums involved, and the limited controls, it is likely only a matter of time until a more severe scandal strikes SMAs, resulting in considerably larger damage to the affected investors. The leading sponsors of SMAs are the major Wall Street brokerage houses, whose recent scandals dwarf anything seen in the mutual fund business.

SMAs have one major real advantage of over mutual funds, and in Sensible Financial’s view, one major perceived advantage. First, the real advantage – you can provide the SMA portfolio manager with a list of investments to exclude (actually, a list of investment categories to exclude)2. This is valuable if you have strong views about certain investments you do not want to hold, and no mutual fund shares those views. Second, the perceived advantage – the portfolio manager can take into account your tax situation in buying and (especially) selling securities. In our view, this “benefit” is of limited value at best. You can do “tax loss harvesting” just as well with ETFs as with individual stocks, and a lot more simply. Consider that a successful SMA advisor will have hundreds or thousands of clients, all following the same basic strategy, and all requiring tax-sensitive trading. You and your broker or financial advisor will have to identify the tax-induced trades you wish to have made (the portfolio manager can’t track the tax situations of all of the SMA’s clients), just as you will in the case of a simpler portfolio. It may well be the case that with more positions (holding individual stocks rather than mutual funds), more positions will be losses available for harvesting. However, there is no reason to believe that the aggregate losses in those positions will be any greater in an SMA than they will in a portfolio of mutual funds, and thus, no reason to believe that the tax benefits will be any greater.

We close with a table summarizing the advantages and disadvantages of SMAs relative to mutual funds. If you’d like to continue this discussion, we invite you to call us at (781) 642-0890, or email us at info@sensiblefinancial.com.

Characteristic Mutual Funds Separately Managed Accounts
Transparency • Major holdings reported quarterly
• Morningstar and other services track performance and style consistency
• “Apples to apples” comparisons among funds readily available
• No requirement for reporting of holdings
• Performance and style consistency not available publicly
• No “apples to apples” comparisons available
Regulation • 1940 Act governs
– Treat all shareholders equally
– Portfolio manager may not take advantage of shareholders
– Allowable expenses and costs limited
• Long history of mutual fund regulation
• SEC enforces
• No specific governing legislation
– Clients can be treated differently
– No explicit control on portfolio manager “front-running,” e.g.
– Allowable expenses and costs not limited
• No SMA regulation history
• NASD, SEC probably share responsibility
Expenses / Costs • Large investors “subsidize” small investors3
• Shareholders pay trading commissions directly (but usually don’t know it)
• Many mutual funds are sold by financial advisors and brokers who add their own “asset management” fees
• Advisors may charge lower, “institutional” fees
• Clients pay trading commissions directly (but may not see these costs)
• Many separate accounts are sold by financial advisors and brokers who add their own “asset management” fees
Income Tax Management • Capital gains embedded in initial investment may imply tax liabilities without enjoyment of the gains4
• In a diversified mutual fund portfolio, some funds will decline, offering scope for tax loss harvesting [the value
• No embedded capital gains
• Holding of individual securities provides scope for harvesting losses for tax purposes (more securities means more are likely to show losses)
Account Tailoring • No tailoring – if you don’t like certain fund holding(s), you must either swallow your concerns, or decide not to buy the fund. • No tailoring – if you don’t like certain fund holding(s), you must either swallow your concerns, or decide not to buy the fund.
Governance • Shareholders elect Board
• Board has fiduciary responsibility to shareholders
• There is no Board – you hire the manager. There is no Board to sue if something goes wrong.
Flexibility / Liquidity • Shares can be sold any day • Closing an SMA requires moving the individual securities to another manager, a potentially complicated and time-consuming task