“Now You Can Avoid Taxes Like the Rich and Famous”
— The Wall Street Journal, Dec. 10, 2024

This headline may sound like hot news — but the ideas presented in the above Wall Street Journal article are actually more than 30 years old.

Separately managed accounts (SMAs) that employ active tax-management have enjoyed impressive growth in popularity, attracting the attention of more and more investors and advisers.

During my career as an independent registered investment adviser, we found tax-managed SMAs to be a very attractive option for some of ou r clients. My wife and I both use them as part of our personal investment plans.

For years, mutual funds dominated the portfolios of a majority of investors, providing the benefits of diversification and simplicity.

The war between actively managed and passive (index) funds raged with indexing becoming the dominant approach due to the low cost and the fact that few managers actually beat the market over extended time periods.

As with many conflicts, I suspect this “active versus passive” debate will continue.

Along came exchange-traded funds (ETFs) that offered the benefits of mutual funds, traded like stocks, generally had lower costs and were more tax efficient.

But back in the early 1990s, a Seattle-based Parametric Portfolios pioneered a new idea: tax-managed SMAs.

The idea was to create an account holding shares of individual stocks in hundreds of companies designed to closely track an assigned index benchmark (i.e., the S&P 500, Russell 3000 Index, etc.) but provided the client with customization, flexibility and tax advantages over mutual funds or ETFs.

The result is that SMAs have become so successful that they’ve drawn a new label: direct indexing.

According to Morningstar, assets in tax-managed SMAs have soared to more than $500 billion, and these products are now offered by a wide range of providers including Schwab, Fidelity, Vanguard, BlackRock and many others.

Here’s why:

Let’s use an SMA that seeks to follow the broad U.S. stock market using the Russell 3000 Index (R3000) as the benchmark. While the index is composed of 3,000 companies (thus its name), the SMA might hold 500 individual stocks that provide a large enough sample to track the index without buying all 3,000 companies.

Now let’s say the stock market (R3000) goes up by 10% for the year, which is very nice. But it’s fair to assume that not all 500 stocks in your account all went up; some would have lost value while others were up for the year.

In fact, while the S&P 500 enjoyed a 28% return in 2021, 91% of stocks in the index had a maximum drawdown of more than 10% at some point during the year, according the FactSet.

Now, here’s where the magic comes in:

The stocks that are down can be sold to capture the loss for tax purposes, and proceeds can immediately be used to buy a similar stock, so you stay fully invested.

I’ve always used the example of Pepsi being sold at a loss and buying Coca-Cola to replace it. That tax-loss can be used to offset gains — now or in the future — even though your portfolio stayed invested to capture market returns.

This strategy is referred to as “tax-loss harvesting,” which has been done by sophisticated investors for years.

Add the fact that many (if not most) discount brokerage firms charge nothing for buying/selling shares makes this very cost-effective.

Note that these tax benefits cannot be achieved with mutual funds or ETFs, since you can only sell shares of the fund, not any underlying holdings.

If the fund is up 10% and you sell, you pay tax on the gain. You cannot ask the fund just to sell shares of stocks held in the fund that are down.

MA/direct indexing firms suggest that these accounts will closely track pre-tax market returns while generating additional after-tax returns of 1%-2% per year.

Professionals refer to this as “tax alpha,” an extra return from tax benefits. It has been my experience that this has in fact been the case.

So, you beat the market on an after-tax basis without taking on additional market risk, making this about the closest thing to a free lunch when investing.

Keep in mind that providers don’t do this for free, so you need to look at manager expense charges. My experience has been that costs are typically 20-50bp annually—but you need to inquire and also ask about any trading costs. 

There are some important additional benefits of SMAs. Shares of existing stock holdings can help establish a new SMA by making in-kind transfers. You can’t do that with a mutual fund or ETF in which your current holdings must be liquidated with gains subject to tax to buy the new fund with cash.

Individuals with existing large single-stock positions can instruct the SMA to block the purchase of that company.

The SMA manager can also help you work out of a large single stock position over time using harvested losses to offset gains in the big holding.

You can have the SMA manager transfer specific shares of high-gain (low-basis) stock to a charity, giving you a tax deduction for the donation while avoiding capital gain taxes on the holding.

Given the wide range of index benchmarks for both U.S. and international stocks markets, tax-managed SMAs can be tailored to your preferences.

There are also a growing number of actively managed offerings if you don’t want a passive/index approach.

And while account minimums have gotten smaller, allowing more investors to take advantage of these products, pricing can make small accounts less desirable.

SMAs can also be used for bonds, providing the benefits of diversification, security selection, institutional pricing and fixed maturities.

It can be difficult for many investors to build a truly diversified and cost-effective individual bond portfolio on their own.

Bonds tend to trade more favorably in larger denominations, making it tough to buy enough issues to be properly diversified.

And care should be taken to do some due diligence on issuers to limit risk, something few individuals have the time or skill to do.

I found SMAs for tax-free municipal bonds to be particularly attractive, with the ability to customize around investors’ goals and even create state-specific mandates.

Santa Barbara County taxpayers may find California tax-exempt bonds particularly attractive as they are exempt from both federal and state income taxes.

With combined marginal tax rates of 40%-50%, after-tax yields provide a great source of income. Morningstar noted that savings from active tax management aren’t as high as for stock SMAs, perhaps about half as much.

Note that investment product selection should be based on your personal situation, goals and preferences.

These tax-managed SMAs are a bit more complicated than mutual funds and ETFs, so getting some help/advice from experienced financial and tax advisers can make sense.

But in the right situations, they truly can help you avoid taxes like the rich and famous.