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Three Advantages Of A Custom Passive SMA For The Taxable Investor

Mar. 04, 2021 4:02 PM ET
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  • Continuing a trend of the past five years, exchange-traded funds (ETFS) grew in assets under management (AUM) in 2020.
  • More investors are using ETFs as they shift from active to passive investing.
  • An ETF may be a tax-efficient option for the taxable investor — but a custom SMA can be even better. Learn what else this choice can provide.

By: Rey Santodomingo, CFA

Article published on: March 1, 2021

Seattle - Continuing a trend of the past five years, exchange-traded funds (OTC:ETFS) grew in assets under management (AUM) in 2020. More investors are using ETFs as they shift from active to passive investing. One favored advantage of ETFs is tax efficiency due to the low turnover associated with index-based investments, in addition to many ETF providers' use of the creation and redemption process to reduce capital gains distributions.

However, the fact remains that the ETF continues to be a one-size-fits-all solution that isn't optimal for everyone. The flexibility of a custom passive separately managed account (SMA) could beat an ETF in terms of tax efficiency in many cases. Let's look at a few examples.

Advantage #1: Tax-loss harvesting

A custom passive SMA may be a superior vehicle for delivering the value of tax-loss harvesting.1 This value comes through realizing tax losses that can be used to offset capital gains. In a custom passive SMA holding many securities, loss-harvesting opportunities are more plentiful because each security is a potential loss-harvesting trade. Even when the market is up, investors can still find losses in a tax-managed portfolio. With ETFs, investors need to wait for the entire market to go down before they can harvest any losses.

Advantage #2: Transition of appreciated securities or concentrated positions

A custom passive SMA allows investors with existing stock portfolios to more effectively transition to an index-based exposure over time. A custom passive SMA manager can analyze an investor's existing securities, decide which ones to keep and carefully sell out of non-index names, using the proceeds to invest in securities that help reduce tracking error2 to the index. It's important in transitions like this to take gains and losses into account, since the sale of each appreciated security can result in capital gains taxes. A custom passive SMA manager can use the losses embedded in the portfolio to help offset any gains realized.

On the other hand, an ETF investor may have a much harder time making a careful transition, because they don't have the ability to work with the granularity of the individual stocks. Often they're stuck with liquidating the portfolio and buying the ETF, which can trigger a large tax bill.

Advantage #3: Double benefit of charitable gifting

A custom passive SMA provides a superior tax-advantaged way to give to charity. This type of portfolio enables clients to gift highly appreciated securities, which provides the benefit of the charitable gift deduction and also helps investors avoid the capital gains tax associated with the position. While an ETF portfolio can also become appreciated, a custom passive SMA will contain highly appreciated securities that have outpaced the market and cap-weighted index-based ETFs in recent years — making them a much more tax-advantageous security to gift. For example, three major tech stocks went up 64% on average in 2020, compared with 18.4% for the S&P 500® Index.

Bottom line: To help obtain better after-tax results, investors may need to consider the key inputs that are unique to their situations. These inputs can include their portfolio's level of appreciation; tolerance for tracking error or speed of transition; and federal, state and local tax rates. When these variables are taken into account, the benefit of a custom passive SMA and tax-efficient management is that investors may get a more optimal after-tax return than they could from an ETF.

1. Tax loss harvesting is a strategy for managing taxes in an investment portfolio. Selling a security that's trading at a loss creates a realized tax loss, which can be used to offset a capital gain realized in the same year.

2. Tracking error is a measure of the risk in an investment portfolio relative to its benchmark index, which results from active management decisions made by the portfolio manager.

S&P 500® Index is an unmanaged index of large-cap stocks commonly used as a measure of U.S. stock market performance.

tax forward

Eaton Vance Investment Tax CenterStay on top of 2021's major tax and investment implications for your clients with our tax-forward insights and needs-based solutions.

Eaton Vance Parametric Investment Tax CalculatorTaxes always matter. See your clients' combined total tax rate, including federal, state and local taxes, right now and hypothetically under the Biden Tax Plan.

Tax-loss harvesting involves certain risks including, among others, the risk that the new investment could perform worse than the original investment and that transaction cost could offset the tax benefit. There may also be unintended tax implications. Prospective investors should consult with a tax or legal advisor before making any investment decision.

All investing involves risk, including the risk of loss.

Not all of Eaton Vance's recommendations have been or will be profitable. The views and strategies described may not be suitable for all investors.

Parametric, an SEC registered investment adviser, provides advisory services directly to institutional investors and indirectly to individual investors through financial intermediaries. Investing entails risks and there can be no assurance that Parametric (and its affiliates) will achieve profits or avoid incurring losses. All investments are subject to potential loss of principal.

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