As interest in direct indexing grows, investors should take care to find the right partners. Consider experience, selection, communication, and tax awareness when building an SMA.
Separately managed accounts (SMAs) are having their day in the sun as an avenue for advisors to offer a greater degree of customization for their clients. That customization can take the form of enhanced tax management, responsible investing considerations, and custom exposures, to name a few. One investment approach that lends itself especially well to SMAs is direct indexing, which is seeing more and more interest on both the demand and supply sides. Cerulli estimates that assets in direct indexing will reach more than $800 billion by 2026.
It’s important to remember that not all providers are created equal. Does the provider have what it takes to deliver on the full potential of an SMA? Technology plays a large part, but a successful direct indexing platform requires more. Technology and humanity go hand in hand along the client account journey as advisors work to design, implement, and service the optimal portfolios for their clients.
Does the SMA provider have the right expertise and scale?
As new players enter the SMA space, it’s critical to assess their expertise. Consider the sophistication level of their service teams and whether they not only are well-versed in investment strategy but can deliver the high level of consultation that custom SMAs require. Do they have the experience of investing through multiple market cycles? Do they have the experience of working with clients of all asset sizes? Do they recommend truly custom portfolios, or do they rely on boilerplate portfolios for complex investor problems? Whether it’s understanding client needs when designing the portfolio, continually looking for ways to improve the optimization process, or helping advisors articulate the benefits to their clients, service is key.
A custom SMA manager must also have a scalable and efficient investment platform to handle a growing number of individual accounts. Advisors should ensure that a provider’s technology can support the sophisticated portfolio management and reporting that comes with custom SMAs. SMA technology requires regular enhancements to the algorithms that underlie the optimization processes and to the engines that drive client-level reporting. Internally developed technology can often deliver more bespoke functionality than modified off-the-shelf solutions built on third-party frameworks. Ensure the SMA provider’s technology is nimble enough to efficiently evolve to account for a client’s unique circumstances.
What types of exposures can the SMA provider capture?
Ask about the provider’s ability to deliver individualized exposures beyond traditional cap-weighted indexes. Are they flexible enough to offer global exposures? How many benchmarks do they have available? Can they combine benchmarks to create a custom exposure? What about factors—not just standards like value and momentum but blends of different factor strategies? And what about different asset types, such as options or fixed income?
Beyond customized market exposure, many investors will seek to incorporate customized responsible investing guidelines. To ensure a manager has the resources to customize an SMA in line with your clients’ values, consider their range of socially responsible options—particularly the number of environmental, social, and governance (ESG) metrics available—and the team focused on responsible investing research and implementation. An increasingly important aspect of responsible investing is thoughtful proxy voting and shareholder engagement. Ensure the provider’s policies around these facets of responsible investing factor into their offerings.
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Beyond access to a dedicated client service team, ask whether investment professionals are available for in-depth conversations. Portfolio managers and investment strategists should be able to partner with the client service team to arrange in-person, phone, or video conferences.
In our experience, especially when working with investors who are higher up the net-worth scale, effectively delivering a custom SMA requires a mix of art and science. The technology is the science, providing efficiency and scale. The art comes from human insight: a real-life person to monitor and execute trades, interpret the results of mathematical models, provide insight and commentary, and act as a sounding board for the client.
It’s also worth kicking the tires on any provider’s research. Are they generating new ideas in tax-managed investing, for example, or finding new data to make the case for responsible investing? Do they have teams dedicated to testing hypotheses, busting myths, and diving deep into the issues that really matter to investors? Visit their website and explore their thought leadership pages. The right provider will make a point of publishing actionable insights on a regular basis, especially during periods of market stress.
How closely does the SMA provider focus on tax management?
For many high-net-worth investors, taxes can represent a larger drag on returns than fees or trading costs. As a result, taxes often have a major impact on the long-term growth of a portfolio. That’s why an SMA provider should take a rigorous approach to tax management.
To begin, find out how long they’ve been tax-managing their clients’ portfolios. It’s one thing to say they do it, but it’s quite another to have deep experience and expertise in this hard-to-get-right field. Investing through the market’s ups and downs and tax policy changes provides valuable perspective that shouldn’t be ignored.
Then ask whether the provider can fund accounts with in-kind securities. Funding an SMA with preexisting securities and tax-efficiently transitioning to an index-like portfolio is a major benefit over exchange-traded funds (ETFs), which investors can only fund with cash. Ideally an SMA provider will help fund the account in a manner that avoids unintended gains and aligns trades with clients’ tax and risk sensitivity. Similarly, can the provider assist in the distribution of securities to fund charitable gifting activities? The process of finding the optimal mix of securities while balancing for taxes and risk is often a process that requires several iterations to get it just right.
Finally, spend time understanding the provider’s approach to harvesting tax losses. How often do they harvest losses? Is it calendar- or trigger-based? What kind of optimization is in place to ensure the risk of the portfolio stays within target and the trades don’t violate any wash-sale rules? Can the provider coordinate tax-management activities across a client’s multiple SMAs? Gauge whether the provider knows how to balance the inherent costs of harvesting trades against the opportunity to add client value.
The bottom line
Successfully managing a custom SMA isn’t easy. It’s worth the time to find just the right SMA provider, one that can continually monitor clients’ portfolios, systematically harvest for tax losses, allow customization to express your clients’ values and unique circumstances, and target a wide variety of market segments—in other words, a provider that delivers market exposures with much, much more. For valued clients looking to make the most of their portfolios, that’s the provider they deserve.
