As a finance professional, I often get asked whether investors should choose separately managed accounts (SMAs) or mutual funds. Both have merits, but SMAs offer distinct benefits that align with the needs of high-net-worth individuals, tax-conscious investors, and those seeking greater customization. In this article, I’ll break down the structural, tax, and performance-related advantages of SMAs over mutual funds—backed by data, calculations, and real-world considerations.
Table of Contents
What Are Separately Managed Accounts and Mutual Funds?
Before diving into the advantages, let’s clarify the basics.
- Mutual Funds: Pooled investment vehicles where investors buy shares. The fund manager makes decisions on behalf of all shareholders, leading to uniform holdings.
- Separately Managed Accounts (SMAs): Personalized portfolios where the investor owns individual securities directly. A portfolio manager tailors the strategy based on the investor’s goals.
Structural Differences
| Feature | Mutual Funds | SMAs |
|---|---|---|
| Ownership | Shares in a pooled fund | Direct ownership of securities |
| Customization | Limited (same holdings for all) | High (tailored to investor) |
| Tax Efficiency | Lower (capital gains distributed to all) | Higher (tax-loss harvesting possible) |
| Minimum Investment | Often low (e.g., $1,000) | Typically high (e.g., $100,000+) |
| Transparency | Limited (holdings disclosed periodically) | Full (real-time visibility) |
Key Advantages of SMAs Over Mutual Funds
1. Tax Efficiency and Control
Mutual funds suffer from a structural tax disadvantage. When the fund manager sells securities at a profit, capital gains are distributed to all shareholders—even if they just bought in. This creates unwanted tax liabilities.
In contrast, SMAs allow for tax-loss harvesting, where losses in certain positions offset gains elsewhere. Suppose an SMA holds two stocks:
- Stock A: Bought at \$50, now worth \$40 (unrealized loss of \$10 per share).
- Stock B: Bought at \$100, now worth \$150 (unrealized gain of \$50 per share).
By selling Stock A, the investor realizes a \$10 loss, which can offset part of the \$50 gain from Stock B, reducing taxable income.
A study by Vanguard found that tax-managed SMAs can improve after-tax returns by 1-2% annually compared to mutual funds.
2. Customization and Personalization
Mutual funds follow a one-size-fits-all approach. If an investor wants to exclude certain sectors (e.g., fossil fuels) or overweight specific industries, they can’t—unless they find a specialized fund.
SMAs allow for:
- Exclusionary screening (e.g., no tobacco stocks).
- Concentration control (avoiding overexposure to a single stock).
- ESG alignment (directly selecting sustainable investments).
For example, if an investor wants a low-carbon portfolio, an SMA manager can exclude high-emission companies while maintaining sector balance.
3. Lower Hidden Costs
Mutual funds charge expense ratios, but they also incur transaction costs from frequent trading—costs that are passed on to investors. SMAs, being individually managed, avoid the drag from excessive turnover.
Consider a mutual fund with:
- Expense ratio: 0.75\%
- Hidden trading costs: 0.50\%
- Total cost: 1.25\%
An SMA might have:
- Management fee: 1.00\%
- Trading costs: 0.10\% (due to lower turnover)
- Total cost: 1.10\%
While the SMA’s stated fee is higher, the actual cost is lower.
4. Transparency and Control
With mutual funds, investors only see holdings quarterly. SMAs provide daily transparency, allowing investors to track every position.
This is crucial for:
- Risk management (avoiding unintended sector bets).
- Tax planning (knowing cost basis before selling).
5. No Style Drift
Mutual funds sometimes deviate from their stated mandate (“style drift”). A “large-cap value” fund might start buying growth stocks if the manager changes strategy.
SMAs adhere strictly to the investor’s guidelines, ensuring consistency.
When Do Mutual Funds Make Sense?
Despite the advantages of SMAs, mutual funds still have a place for:
- Smaller investors (SMAs often require \$100,000+ minimums).
- Passive strategies (index funds are cost-effective).
- Diversification in niche markets (emerging market debt, etc.).
Final Thoughts
For investors with sufficient capital, SMAs provide better tax outcomes, customization, and cost efficiency than mutual funds. However, they require more active involvement and higher minimums.
