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Finding Value With A Separately Managed Account
BY Kathrin Schindler, Deputy Editor, Citywire Engage
ETFs vs SMAs: Who’s winning the ESG battle?
SMAs on track to become formula of the future
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SMAs aren’t new, but in many ways they feel like the vehicle of the future. Once limited to institutional investors and ultra-high-net-worth individuals, they are becoming more available to the general strata of investors. Tax efficiency and the ability to reflect personal convictions – such as those relating to ESG themes – are major drivers behind SMA growth. In this special report, we shine a light on the factors that contribute to their rising popularity, exploring how they stack up against ETFs when it comes to sustainable investing and find out what’s in store for them.
Portfolio, meet possibility
AN ACTIVE LOOK AT CUSTOM SMAs
BACK TO THE TOP
Why cash-flow can be a kingmaker after a crunch
Opportunities in climate change
GOING DIRECT
Bond investing gets personal
SMAs on course to take center stage
By Stephanie Hoppe A staggering $3tn worth of assets is set to be housed in separately managed accounts (SMAs) by the end of Q2 2022, according to some of the world’s largest investment managers. And, asset managers are experiencing huge inflows from investors eager to benefit from the pricing flexibility that has traditionally been reserved for larger client relationships. ‘The market quadrupled over the past decade – growing to almost $2.5tn at the end of last year alone,’ said Sam Marciano, head of SMA distribution at Franklin Templeton. ‘This is driven predominantly by shifts in client demand towards solutions providing greater control, transparency, and lower costs.’ Russ Tipper, senior VP and director of wealth management product at Capital Group, added: ‘Demand for our equity and fixed income strategies has surged 52% year-over-year to just shy of $35bn in assets under management in 2021 – and more than 800% year-over-year since we launched our first SMA strategies in 2013. ‘We expect demand for SMAs to continue to rise, particularly as the industry shifts from more of a brokerage to an advisory-based model. We recently launched three new equity strategies to cater to growing demand, which specifically invest in companies with high-quality products and leading market share positions. We also offer muni SMAs with a full range of personalization as part of our ongoing commitment to expand our suite of SMAs and bring our proven track record of investment success to a wider number of investors.’ AN INVESTOR'S BOON SMAs are increasingly targeted toward wealthy but not ultra-wealthy retail investors, with at least six figures to invest. A key driver of demand by high-net-worth individuals is greater ‘tax control’ than that afforded by mutual funds. ‘SMAs are no longer just for the wealthy. UMA platform technology has democratized access to these vehicles and they are now accessible to the mass affluent and across nearly every wealth sponsor,’ said Gregory Weiss, head of managed accounts at BlackRock. ‘These technology advancements coupled with two major trends shaping the US wealth management industry are driving a resurgence in SMAs. Investors are demanding to personalize their portfolio to optimize for after-tax return and tailor for their ESG preferences. Advisors are increasingly outsourcing investments to asset managers to build scale and free up time to provide more holistic advice including financial planning, liability management, insurance and annuities. Bottom line, the SMA resurgence is driven by many advisors embracing an outsource model to scale their practices and the need to personalize each client portfolio.’ Because each client owns the securities individually, SMA managers are able to perform tax-loss harvesting to offset gains and lower investors’ tax bill in contrast to the capital gains distributions that apply for all mutual fund shareholders. ‘Many other vehicles are a one-size-fits-all approach while an SMA has the opportunity to be a one-size-fits-one. Customization options allow investors to access high-quality investment strategies that they can personalize to their own unique tax,’ explained Tipper. ‘For our suite of SMA strategies, particularly our muni-bond SMA strategies, customization options will include on-demand tax gain and loss harvesting and the ability for investors to identify bonds to sell or select positions to freeze. As well as exclusionary requests by the investor according to state, user, credit quality and sector.’ Outside of lower barriers to entry and tax efficiency, customization is another key driver behind the rising popularity of SMAs. These investment wrappers differ from pooled vehicles like mutual funds because each portfolio is designed around individual investors’ requirements.
Every client’s financial journey is different and SMAs offer the ability to tailor their portfolio to their needs,’ said Weiss. ‘At BlackRock, we see personalization is becoming the new product, taxes are the new form of alpha and the experience between the advisor and the client is paramount. Our objective is to help advisors build portfolios personalized to the client’s risk, objectives, tax situation, and values. Our vision is to partner with advisors to build multi-asset, multi-vehicle portfolios combining SMAs, mutual funds and ETFs, personalized using tax, option, ESG, and factor overlays, delivered via a convenient experience from proposal to onboarding through tax alpha reporting.’ A FIT FOR THE CLIMATE-FOCUSED Increased demand for environmental, social and governance portfolios is adding momentum to SMA strategies that apply sustainability-focused ESG criteria. A shift away from traditional style box investing to outcome-oriented solutions is another contributing factor to the popularity of SMAs, as investors express greater desire for products addressing income, longevity and volatility risk. Direct indexing has become another popular trend driving growth in the SMA industry as it enables investors to purchase individual securities with a lower-tracking error to an index. Industry experts expect for the asset class to continue its upward trajectory fuelled by its continuing expansion across asset classes and security types. ‘SMA offerings within the industry span asset classes, market caps and geographies to include equity portfolios across the US, international, global and emerging markets as well as fixed-income portfolios across the credit and maturity spectrum,’ explained Marciano. ‘While historically the SMA industry has been more limited in terms of the types of securities that can be included within a strategy – typically liquid, US dollar-denominated securities – developments over the past decade have enabled SMAs to take a hybrid approach by investing in both individual securities and no-fee funds, which has allowed asset managers to include a wider array of exposures in a retail SMA, which are impractical to hold as individual securities, either due to operational limitations or not having a sufficient investment minimum to properly diversify into the additional exposures. The highest in-demand asset class has historically been in the traditional US active large cap, international equity and US fixed income – but more recently direct indexed equity, ESG and other customized solutions have been growing in demand.’
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Lower barriers to entry and vast flexibility mean that separately managed accounts will continue to be a hit among investors into the near future
OTHER FACTORS CONTRIBUTING TO DEMAND FOR SMAs INCLUDE: – wirehouse research teams increasingly asking for strategies to be available in multiple vehicles, not just mutual funds, spurring managers to launch more SMAs; – advisors increasingly outsourcing investment management, whether that be bond ladders that they might have run themselves 10 years ago, or complete client portfolios, leading to the rise of model portfolios, many of which are structured as SMAs; and – model portfolios being pushed within large wirehouses and broker-dealers as they seek to exert greater control over client investments, leading to increased offerings from the home offices and third-party managers.
Please refer to the previous page for important disclosure information. Past performance is no guarantee of future results. For additional information, contact an Amundi US Sales Specialist at 800-622-9876 or amundi.com/usinvestors/sma. Amundi Asset Management US, Inc, 60 State Street, Boston, MA 02109. ©Amundi Asset Management US.
Trying to keep track of where markets are headed is especially challenging now. Geopolitical events, rising inflation and complex supply chain issues are putting pressure on the economy. Working with an experienced management team through a flexible structure like a separately managed account (SMA) can be beneficial. In this Q&A with Amundi US’s Jeff Kripke, he explains more about the value of SMAs and his outlook for markets over the near term. CW: What are the potential benefits and opportunities of your SMA vehicle? JK: Separately Managed Accounts can help provide more control over a client’s investments and provide increased transparency when it comes to individual trades in the portfolio. They are also designed to offer tax efficiency through a range of personalized tax-sensitive investing techniques. Perhaps more importantly, these vehicles allow for a range of customization. ESG customization – which allows client portfolios to exclude securities that do not align with their ESG or value-based preferences – is one of the main selling points of SMAs. CW: Given the uncertainties in the market (Ukraine, Inflation, Rising Rates) what is your outlook? How are you positioning your portfolio in light of those views? JK: The level of uncertainty is putting pressure on investors and we are seeing some folks holding back from buying. Ultimately, I think that’s probably temporary. We have been pro-growth, largely because of the end of Covid and still are, although inflation is rising. We think inflation will probably remain elevated for a while. That said, this is a unique time to focus on what we do best in our opinion, which is to identify companies that have unique pricing power and are more likely to withstand uncertainty. These are companies that have good management teams, have high market share in their industry and are global. They have historically outperformed even under challenging conditions. In light of that focus, as of March 31 we have been reducing our exposure to consumer discretionary, financials, and industrials. We do believe there are still opportunities for growth within the technology sector if you are disciplined - many of these companies have had strong financials and good earnings growth. CW: There are many ESG/Sustainable strategies in the market, what makes your approach different/better? JK: I think one of the biggest things is that we have always been running concentrated portfolios. So we’re taking fewer and bigger positions. As a result of that, ESG is a part of our strategy in Pioneer SMA because we want to make sure these companies are going to be competitive over the long term. In a concentrated portfolio if a company drops significantly, the drag on a portfolio can be the difference between performing well and having a year that is flat or negative. So we’re really looking closely at any factor that could impact the performance of a company - ESG issues can be critical to the long-term performance and viability of any company. CW: What does it mean to be a sustainable business in your portfolio? JK: Obviously there are the financial components. We want to see a good balance sheet; we want to see a defensible business model within a given industry. However, the highest quality companies have additional components that really make them stand out. Typically, these are companies that treat their employees very well. Workers are well compensated, benefits are good, if this is a company where employees can have a secure job for a long time it cuts down on training costs and the business itself tends to do better over time. There are other factors like resourcefulness that help make a business sustainable. For example, historically, some of the best performing companies throughout the supply chain crunch are those that have been able to pivot and start handling their own logistics or were able to source necessary supplies and bring them in on their own. Companies that have the ability to think through and execute on things like that are likely to be more sustainable overall. When we start to look at issues like climate risk, resourcefulness becomes an even bigger component of whether or not a business is positioned to last, in our view. CW: How have you delivered such strong downside mitigation over the years? How do risk management and valuation play into that approach? JK: When we’re looking at the valuation of a company through a risk management lens, we’re looking at a couple of things. Balance sheets again are important, but we also want to look at the brand. How do customers think about the brand and the identity of the company? Is it generally positive? In the social media age, it’s important to take reputational factors into account because there is much more consumer impact in the sense that consumers will choose companies that they align to. Or, conversely if something happens, the risk to a company’s reputation has the potential to be larger now. Even more broadly than that, we’re looking at whether a company is being a good corporate citizen. We tend to prefer companies that are making a positive impact, have a good internal culture, treat their employees well, and so on. These kinds of companies have generally exhibited less risk. Then on the valuation side, we want to make sure we aren’t overpaying. So once we’ve identified what we feel like is fair value, then we’ll be patient. If a company is expensive, we’ll wait it out until we see a potential opportunity. CW: You have an emphasis on secular technology themes (such as 5G, AI, etc), how do these apply to the portfolio? JK: When we are considering companies, these themes can be good guideposts. We’re looking for companies with the potential to outperform and be sustainable, which tends to lead us to businesses that are making use of new technologies. These are companies that have innovative business models, they are more sustainable from an ESG perspective, and more relevant from an economic perspective. In our view, a sustainable business has the following characteristics - a competitive advantage, financial strength and a strong or improving ESG profile. CW: What sets your Pioneer SMA apart from others in the marketplace? JK: We have been able to provide competitive performance and mitigate downside risk because of where we look for opportunities and because we’re running a concentrated portfolio of high-quality companies. There are a lot of managers that say that, but our strategy has been vetted by a number of different stakeholders. As I said before, we spend a lot of time on our positions before we take them because we take larger positions in fewer companies. Pioneer SMA is built around companies that have outperformed historically and, in our view, have the potential to perform well in the future. Our risk management framework is unique in that it not only includes scanning for quality companies from a balance sheet perspective but also from an ESG/sustainability perspective. We’re really focused on companies that are ”doing good, while seeking to do well” which means we believe integrating ESG analysis into the portfolio can help pursue competitive risk-adjusted returns over time.
Faced with a new level of volatility in the market, a separately managed account can be a source of value
Jeff Kripke Senior Vice President, lead portfolio manager PIONEER SMA
BY DAVID COX 2022 is widely regarded as a critical moment for ESG-focused funds. While interest in sustainable investing has soared in recent years – global sustainable fund assets reached $3.9tn in September 2021, according to Morningstar – pressures are mounting due to high research costs and hits to major growth stocks that have helped to accelerate the expansion of the ESG sector. At the same time, investors have never been more attuned to the ways in which their investments have the potential to influence real-world outcomes. ‘Over the past couple of years alone, we’ve experienced a global pandemic, a long-overdue racial justice reckoning, extreme weather events, and heightened geopolitical tensions,’ says Emma Smith, communications director at Ethic – a data-driven technology platform that creates passive custom-built portfolios for sustainability-focused investors. ‘This confluence of events has ignited the general public’s interest in sustainable investing, driving record inflows into ESG strategies.’ Given the boost of investor interest towards ESG – and the pressures created by the uncertain global financial outlook – it is crucial for fund managers to find the most suitable investment vehicle that is effective at managing every individual’s set of assets. USEFUL WRAPPER Two of the most commonly-used tools out there are exchange-traded funds (ETFs) and separately managed accounts (SMAs) – which, as Pierre Caramazza, head of US product and specialty sales at Franklin Templeton, points out, are both essentially wrappers that provide investors with access to a particular strategy. The growing interest in ESG has precipitated the rollout of numerous ETFs which incorporate ESG mandates, while SMAs comprise a mixture of securities which can provide investors with diversified exposure to various indexes and benchmarks. While ETFs represent the most straightforward option for those strapped for time, SMAs stand out through the level of customization that they offer, providing value-driven investors with greater freedom to create a portfolio that reflects the issues they care about the most. In addition, because SMA investors own the underlying securities, they can choose to be an active shareholder, working to influence corporate behavior by voting proxies or filing shareholder resolutions. ‘The ability to customize an investment strategy through special screens or restrictions that are more valued by an individual is an inherent quality of SMAs,’ says Caramazza. ‘This allows clients to exclude specified securities, or even avoid certain industries or sectors. This process may involve ESG screens such as excluding any oil producers and tobacco companies, companies with a percentage of revenues from the production of weapons, or specific companies that are known to be significant carbon producers.’ In the case of Aperio – part of BlackRock’s US Wealth Advisory division – SMAs have enabled managers to create a broad spectrum of custom-built sustainable portfolios for clients ranging from institutional investors to non-profit organizations. Nelli Oster, the company’s director of ESG/SRI, says SMAs have made it possible to create a faith-based public equities portfolio, constructed to align with the values of the Reform Jewish Movement, and an environmentally focused portfolio for a foundation promoting climate solutions and conservation, which tilts towards companies solving problems related to climate change and those with a relatively low carbon footprint. However, SMAs are not necessarily suitable for all investors. Their fee schedules are typically higher than that of ETFs, which often have attractively low operating expenses. ‘SMA providers have asset minimums for equity and fixed income SMAs,’ says Nick Elward, senior vice president and head of institutional product and ETFs at Natixis Investment Managers. ‘For equity, one often sees minimums of $100,000 per strategy. While for fixed income, minimums are usually around $250,000 per strategy. These reasonably high minimums for a single investment strategy tend to mean high-net-worth investors are those who use SMAs. ETFs, on the other hand, allow investors access to strategies with no minimum investments.’ FINDING THE RIGHT FIT Smith says that the investors who are best suited to SMAs are those that want index-like exposure with the added benefits of values customization, and when relevant, opportunities to manage the liability which comes with their higher tax bracket. SMAs allow investors to sell stocks at a loss, which reduces their aggregate capital gains and thus a portion of their taxable income. ETFs tend to be more attractive for cost-conscious investors. ‘While ETFs are often amongst the lowest priced vehicles, many investors prize the greater customization available in an SMA wrapper,’ says Caramazza. ‘If an investor does not want to spend the time thinking about the details involved in customization, or is looking for the lowest possible price point, then the ETF vehicle might be a good fit.’ The nature of SMAs also makes them a far more flexible option than ETFs, in case a client’s needs or preferences change over time. An investor may decide that they would like to shift the relative weight of ESG problem areas over time, as well as the relative importance of values against tracking error and taxes – all of which are far easier to manage with an SMA. ‘Clients’ personal preferences and tax and other considerations may change,’ says Oster. ‘The economic and market conditions also evolve. A client’s portfolio may therefore end up being more of a journey rather than a static strategy, modified over time to reflect their latest preferences and other factors.’ Smith predicts that the adoption of SMAs as a sustainable investing vehicle will accelerate further still as custodians begin to make fractional shares available to advisors. She also points out that investors are becoming acutely aware of so-called industry greenwashing, which makes them more skeptical of one-size-fits-all approaches such as ESG-themed ETFs which provide very limited transparency as to whether the holdings really reflect their values. ‘Investors want to know what’s under the hood of their portfolios,’ she says. ‘Therefore a green fund that offers minimal transparency into its underlying selection methodology is likely to miss the mark for many environmentally conscious investors. ‘Not only that, it may attract the attention of regulators,’ she says. ‘The SEC has made clear that it will be reviewing the degree to which advisors and funds are potentially misrepresenting their products’ sustainability credentials. Against this backdrop, many advisors are turning to SMA providers that offer greater transparency into their ESG methodologies.’
Two fund models are best-suited to meeting the needs of the modern investor. We see which profile suits each
Allspring Global Investments’ tech-enabled separately managed account (SMA) platform, Remi, partners with financial advisors to build and manage personalized fixed income portfolios. Powered by Remi’s portfolio construction and tax optimization investment engine, Allspring delivers results that reflect clients’ values, unique goals, and tax preferences via SMAs. Today, Remi provides customization options for taxable and tax-exempt fixed income portfolios, with equities forthcoming—including direct indexing strategies—as we evolve the future of Remi to offer more portfolio possibilities. Meet Remi—crafting custom solutions We believe one-size-fits-all products do not give the flexibility investors need when it comes to balancing their risk preferences and tax liabilities. Compared with exchange-traded funds and mutual funds, SMAs allow far greater customization with respect to individual holdings and tax management. Remi enables financial advisors to provide clients with real customization options to help achieve clients’ unique investment objectives, whether starting from cash or transitioning an existing portfolio to a customized managed solution. Take the burden out of taxes When discussing growing clients’ assets, the conversation usually focuses on returns or alpha generation, without much attention paid to after-tax returns. For many high-net-worth investors, decreasing tax liability creates an opportunity to increase net gains and after-tax returns. Remi can provide full-life-cycle tax management of portfolios through various means:
Disclosures: Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Income from municipal securities is generally free from federal taxes and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal alternative minimum tax. Allspring Managed Account Services (the firm) is a unit within Allspring Global Investments and is responsible for the management and administration of the Allspring Funds Management, LLC, retail separately managed account portfolios (wrap portfolios). Subadvisory services are provided by Allspring Global Investments, LLC, a registered investment adviser and wholly owned subsidiary of Allspring Global Investments Holdings, LLC. Allspring Global Investments does not provide accounting, legal, or tax advice or investment recommendations. Investors should consult their tax advisor or legal counsel for advice and information concerning their particular situation. Allspring Global InvestmentsTM is the trade name for the asset management firms of Allspring Global Investments Holdings, LLC, a holding company indirectly owned by certain private funds of GTCR LLC and Reverence Capital Partners, L.P. These firms include but are not limited to Allspring Global Investments, LLC, and Allspring Funds Management, LLC. Certain products managed by Allspring entities are distributed by Allspring Funds Distributor, LLC (a broker-dealer and Member FINRA/SIPC). FOR INVESTMENT PROFESSIONAL USE ONLY © 2022 ALLSPRING GLOBAL INVESTMENTS HOLDINGS, LLC. ALL RIGHTS RESERVED. PAR-0422-00129
Remi, of French origin, means “one who steers the boat” or “takes the helm.”
Systematic loss harvesting Intelligent management of asset holding periods Smarter cash withdrawals from the account Tax liability management to meet client objectives Tax-lot-level decision-making Deferred gains by holding an asset with embedded gains (incurring tax) Managing highly appreciated assets Avoiding violation of the wash-sale rule
Elevating your client’s experience Remi was built to make the transition process of client portfolios to a professionally managed solution intuitive and efficient. Our dedicated team of specialists work with financial advisors to understand their clients’ needs and objectives. Based on the preferences input by the financial advisor, Remi seamlessly generates custom fixed income proposals for each unique situation—both cash proposals and transitional scenarios. On average, advisors request four different proposals per client mandate, allowing for the flexibility, transparency, and ability to explore all possible outcomes and trade-offs.
Remi helps financial advisors intuitively match their clients’ life goals with tax-efficient separately managed investment solutions. We provide a clear pathway to solutions managed by a proven portfolio management team with a multi-decade track record of innovation in the space.
BY BAILEY MCCANN Separately managed accounts are not new. The structure has been around since the 1970s, though historically it has been somewhat complex – mostly due to the level of customisation and individual administration involved. As a result, minimums to open an SMA were high, which naturally limited the audience to institutional investors and the upper tiers of ultra-high-net-worth individuals. But for investors that could meet a $50,000-plus minimum, SMAs offered distinct advantages. This is what is currently driving demand for the service. CUSTOMIZATION DRIVES GROWTH Within an SMA investors can own individual securities, add alternatives or be more tactical in how they trade. Advisors who work with investors on their SMA accounts note that these features are attracting new interest. Ultra-high-net-worth investors, executives, and individuals may be getting stock options through work that need a separate account as well. Advisors have responded by using SMAs to help manage those shares and also build concentrated portfolios that take a view on ESG or may include specific investment factors that are relevant to a client’s portfolio goals. ‘We’re getting a lot of questions and data requests about ESG solutions,’ says Chris Volpe, head of wealth management at Informa Financial Intelligence. ‘There are so many ways to construct an ESG portfolio, it can be challenging to go with an off-the-shelf product or a set of products if you’re trying to drill down to a specific type of ESG exposure. That’s where we’re seeing more interest in using SMAs. And there are more questions coming on alternatives and real estate given the current market environment.’ Volpe expects current volatility and the growing focus on ESG to increase this demand over time. ‘The investor pool using this type of account is growing and I think there’s just a broader awareness now about different types of investment strategies where mutual funds, for example, aren’t as competitive.’ Virag Shah, portfolio strategist at Van Leeuwen & Company agrees. ‘There are more investors that want to hold individual securities or they are doing laddered fixed income portfolios and the SMA structure becomes the solution in those cases.’ He says while there are tax efficiencies built into ETFs and there are tax-aware mutual funds, there is more an advisor can do within the SMA structure in terms of tax-loss harvesting and tax-managed strategies that appeal to high-net-worth investors. He says: ‘We’ve worked with executives, for example, that have really significant exposure to their companies or a particular asset class, and they are finding value in being able to do more to manage the tax consequences of that.’ DIRECT INVESTING IS KEY As investors move toward greater sophistication within portfolios, direct indexing has come to the fore as a solution to provide customization while maintaining diversification and tax advantages. Direct indexing is an approach to index investing that involves buying the individual stocks that make up an index, in the same weights as the index. These indexes are created within the separately managed account and their use is growing fast – recent research from Cerulli Associates expects direct indexing to grow at an annual rate of 12% over the next several years1 – faster than the projected growth of ETFs or mutual funds. Asset managers have moved to capture this demand by offering solutions to advisors. Some have acquired technology to make their platforms while others are building their own. Shawn Jaberzadeh, vice president of Dimensional Fund Advisors, says his company opted to build its structure based on feedback from its advisor community, implementing features and functions that weren’t readily available in the market. In September of last year the firm unveiled its expanded SMA offering, the SMA Center, which supports customization, tax management, and helps advisors manage issues like timely proxy voting. ‘Advisors and investors really expect a seamless user experience at this point,’ he says. ‘While technology has certainly made it easier to set up these solutions, we felt like there was more to do in terms of creating a platform that goes beyond the basics, [a platform that] offers greater transparency and helps advisors manage all the inputs they are receiving from the market and investors.’ On the acquisition side, big deals are bringing direct indexing to the mega platforms. In March last year, Morgan Stanley acquired Eaton Vance, and with it Parametric – one of the pioneers of direct indexing. Parametric’s direct indexing capabilities have focused on tax management but they also offer a high level of index customization that can be responsive to investors who want to take more thematic views on issues like ESG. ‘We think there’s a growing recognition within the industry and among investors that there are certain types of investor portfolios that really benefit from more aggressive tax management than what you can achieve with ETFs or mutual funds,’ says Paul Bouchey, global head of research at Parametric. ‘If we see additional changes to the tax code, an advisor being able to provide that capability adds value. We also think the desire for customization is going to continue to grow over time. There are investors who want to focus on income, for example, or build out specific factor exposures and there are more opportunities to tailor those strategies by holding the underlying securities.’ In April, Charles Schwab launched a direct indexing solution to capture this demand. The solution has a $100,000 minimum – which is lower than some of its competitors. Jalina Kerr, managing director of client experience for Schwab Advisor Services, says the benefit of bringing direct indexing to a platform of Schwab’s size is the ability to help advisors scale. ‘We spent a lot of time on what we could do digitally to extend the scalability, which we think is really important to the advisor community. They want to be able to offer competitive solutions, but from a business perspective you also have to be able to scale those solutions as well. And with our platform, we can provide the tools to do that.’ Going forward, the pivot to direct indexing and growth of ESG strategies will likely continue to drive demand for SMAs. While it is unlikely that SMAs will become as common or as low-cost as ETFs and mutual funds, their use by advisors to offer custom solutions and support tax management makes them an optimal tool in the advisor toolkit.
Interest in SMAs growing as investors look for investment strategies that are customized and tax-advantaged
1Source: “Direct Indexing Assets to Double by 2025: McKinsey,” FundFire, Oct 6, 2021. 2Tax Alpha is defined as net after-tax excess returns minus net pre-tax excess returns. Excess returns are portfolio returns minus benchmark returns. 3Source: Morningstar No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Neuberger Berman Canada ULC is a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended. In Canada, Neuberger Berman Canada ULC is registered as: (i) a portfolio manager and exempt market dealer in Alberta, British Columbia, Manitoba, New Brunswick, Nova Scotia, Ontario, Québec and Saskatchewan, (ii) an investment fund manager in Ontario and Québec, and (iii) a commodity trading manager in Ontario. Neuberger Berman Investment Advisers LLC is a registered investment adviser. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC. © 2022 Neuberger Berman Group LLC. All rights reserved.
Direct indexing has brought customization to the investment world at large as several asset managers recently made headlines by acquiring independently owned shops that invest directly in the underlying stocks of market indices rather than in ETFs or mutual funds. McKinsey reports that assets under management in direct indexing have tripled over the last three years to $215 billion, and could double by 2025. Why do asset managers see potential in serving clients through direct indexing SMAs? By leveraging technology, providers can customize portfolios based on an individual client’s investment needs, allowing advisors to look beyond generic vehicles such as ETFs and mutual funds to account for the client’s liability stream, risk profile and charitable gifting in ways not contemplated a few years ago. Consider that for taxable clients, taxes are the largest expense—not trading costs, custody, or management fees. One of the biggest advantages of an SMA is the ability to pass-through losses directly to the client to apply against capital gain liabilities—which is not available with mutual funds or ETFs. For clients seeking index exposures, this tax-management benefit can potentially result in 1-2% additional after-tax alpha. The question we find ourselves asking is, why limit this level of customization to only passive index exposure? Broadening the scope from direct indexing to what we call direct investing, advisors and clients may benefit from applying the same customization to active, hedged or client-designed strategies alongside their core allocation. When investing in an active management strategy, consider the following:
The primary vehicle available to investors are mutual funds, which can be relatively tax- inefficient. Looking across the Morningstar U.S. Equity Large Blend category, taxes paid (pre-tax return minus after-tax return) are around 3.2% over the last 10 years, on average; the amount is similar for U.S. Equity Small Blend. As a result, an investor seeing a 10% annualized pre-tax return may receive only 7% after-tax. With tax-efficient SMAs, this tax drag on pre-tax capital can be reduced, or potentially eliminated, given the ability to harvest losses.
Ram Ramaswamy
Jacob Greene
MD, Senior PM, Head of NB Custom Direct Investing (CDI)™
Head Strategist
This after-tax benefit is just one feature of custom SMAs, clients can also create completion portfolios, add factor tilts and incorporate ESG values into their investments. Advisors also greatly benefit, as taking advantage of a direct investing platform offers streamlined operations from digital client account opening to reporting after-tax performance, all leveraging cloud-based architecture. This frees up more capacity for an advisor to focus on meaningful client engagement. We are still in the early innings of direct investing, but we believe investors are better served by advisors being able to align their investment, liability, and risk objectives through customized SMAs.
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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.
Three Advantages of a Custom Passive SMA for the Taxable Investor
Rey Santodomingo, CFA
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. 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) can 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 is a superior vehicle for delivering the value of tax-loss harvesting. 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 error 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 offset any gains realized. On the other hand, an ETF investor has 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®. The bottom line To solve for optimal after-tax results, investors need to take into account 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 the investor can get a more optimal after-tax return than they can from an ETF. Visit www.parametricportfolio.com
Managing Director, Investment Strategy
“The ETF continues to be a one-size-fits-all solution that isn't optimal for everyone”
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks. ©2021 Parametric Portfolio Associates® LLC. All rights reserved. 800 Fifth Avenue, Suite 2800, Seattle, WA 98104. NOT FDIC INSURED. OFFER NOT A BANK GUARANTEE. MAY LOSE VALUE. NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY. NOT A DEPOSIT.
WILL SCHMITT
Three gatekeepers tell us how they do due diligence on SMAs, what’s driving demand, and where things are going next
Are SMAs becoming more popular at your firm? They’re becoming more popular, and we are also seeing that more firms are launching them. Firms that weren’t doing this five years ago are now in the business, and that’s helping to increase the popularity. What’s driving this? I think this is a big client push, because clients are realizing they want to have more access to different vehicles. It’s also coming at the advisor level as well. There’s just an advantage from a fee standpoint, and a customization standpoint, to have multiple vehicles, and SMAs fit that role.
Are you seeing a decline in any other investment vehicle’s popularity as a result? We are seeing more popularity with the SMAs, and likely, the money is coming away from mutual funds, but I wouldn’t want it to be portrayed that mutual funds are going away or that they’re not popular. It’s just the customization, the potential for lower fees with an SMA, that makes it more desirable for clients who can meet those investment minimums. For which type of clients do SMAs make the most sense? Given that SMAs have higher minimums, the clients who usually fit that mold have more sizable assets. Also, ones who want more control over trade, taxes or customization. When it comes to things like values aligned or ESG, that can be more easily implemented in an SMA format. Which categories of SMAs are most popular? The reality is it’s a lot easier to do it within equities because it’s easier to replicate. Within fixed income, it’s a little bit harder, but there’s still demand there.
Are SMAs becoming more popular at your firm? SMAs represent about 10% of our firm’s assets under management, so most of our clients don’t use them. Most of our clients are either using funds or ETFs. There are some situations where we use SMAs, whether it’s for customization or tax issues for the client, where they would prefer the SMA vehicle over a fund. Does your due diligence differ when assessing SMAs? I think our research process is the same for both. Whether it’s a fund or separate account, we’re really trying to understand the manager, because that’s the most important part. Whether it’s a mutual fund or an SMA, we want to understand the process, the people, the track record. Where there is increased demand for SMAs, is that being driven by advisors or asset managers? It’s probably usually from the advisor, because they’re working with their client, trying to find the best vehicle, the best way to structure the client portfolio. How do you use SMAs? We run a dividend growth SMA internally. If a client has a number of those types of stocks already in their brokerage account, rather than selling all those stocks and investing them in a mutual fund, we’ll incorporate those and manage a more custom, tax-sensitive version of our separate account strategy.
Do you offer direct indexed strategies? We don’t do direct indexing at this time. It’s something we’ve looked into because, certainly from a tax perspective, something like that could be beneficial.
Are SMAs becoming more popular at your firm? I’d say it’s been pretty steady in the past couple of years. We’ve had about $10bn in SMA appreciation over the past five years and most of that is market appreciation. On average, I think we add about 10 to 15 SMAs per year. But on the flows side, I don’t see really huge growth numbers. Is interest in SMAs being driven by asset managers or advisors? Mostly advisors. They just like to make their own decisions, they pick up different SMAs, and then they make their own models. Do you offer direct indexed strategies? That’s a pretty hot topic, and our team has been spending time on this. On the ESG side, some people want a more customized index-based ESG choice. We do have offerings, but apparently they cannot cover all the demand from the field, so we have to do a little more work there to maybe expand the offerings. Does the due diligence process differ compared to mutual funds or ETFs? Overall, I would say the core of the due diligence process is pretty much the same. We try to pay attention to the firm, to the team, to their process, and of course, the portfolio construction. SMAs are available for lower fees but with less flexibility – as in we don’t have any flexibility with those fees, whereas in a mutual fund, a lot of times, we do have flexibility.
NICOLE PIPER Direct indexing was once considered a niche part of the industry. It was practiced by smaller firms for specific types of clients. This changed in 2020 as some industry giants sat up, took notice, and got out their checkbooks. Last year alone, four of the biggest fund managers acquired shops specializing in direct indexed strategies or the technology behind this approach to investing. Morgan Stanley Investment Management acquired Parametric via its $7bn purchase of Eaton Vance, BlackRock bought Aperio for $1bn, JP Morgan Asset Management purchased 55ip, and Goldman Sachs Asset Management bought Folio. ‘This is not niche,’ said Dan Simkowitz, head of investment management at Morgan Stanley, who made it clear that Parametric’s SMA offering was a major factor in the asset manager’s acquisition decision. ‘This is core to our secular view of the asset and wealth management market over the next 10 or 15 years: Customization is going to be a pillar of growth and a pillar of value to clients.’ Simkowitz told Citywire that although some institutional or sophisticated retail investors have been focused on direct indexing via SMAs for some time, its move into the mainstream has been driven by two recent trends: ESG and tax benefits. ‘You have these two big secular interests that are going on that are perfect for customization: one being tax volatility and the second one being sustainability. These things line up perfectly around customization,’ he said. Simkowitz is not alone in holding this view. Increased tax awareness, the rise of values-based investing, and technological innovation have combined to catapult direct indexing, an approach that by default can only be delivered via an SMA, to the forefront of the asset management industry.
Are SMAs becoming more popular at your firm? They’re becoming more popular, and we are also seeing that more firms are launching them. Firms that weren’t doing this five years ago are now in the business, and that’s helping to increase the popularity. What’s driving this? I think this is a big client push, because clients are realizing they want to have more access to different vehicles. It’s also coming at the advisor level as well. There’s just an advantage from a fee standpoint, and a customization standpoint, to have multiple vehicles, and SMAs fit that role. Are you seeing a decline in any other investment vehicle’s popularity as a result? We are seeing more popularity with the SMAs, and likely, the money is coming away from mutual funds, but I wouldn’t want it to be portrayed that mutual funds are going away or that they’re not popular. It’s just the customization, the potential for lower fees with an SMA, that makes it more desirable for clients who can meet those investment minimums. For which type of clients do SMAs make the most sense? Given that SMAs have higher minimums, the clients who usually fit that mold have more sizable assets. Also, ones who want more control over trade, taxes or customization. When it comes to things like values aligned or ESG, that can be more easily implemented in an SMA format. Which categories of SMAs are most popular? The reality is it’s a lot easier to do it within equities because it’s easier to replicate. Within fixed income, it’s a little bit harder, but there’s still demand there.
Are SMAs becoming more popular at your firm? SMAs represent about 10% of our firm’s assets under management, so most of our clients don’t use them. Most of our clients are either using funds or ETFs. There are some situations where we use SMAs, whether it’s for customization or tax issues for the client, where they would prefer the SMA vehicle over a fund. Does your due diligence differ when assessing SMAs? I think our research process is the same for both. Whether it’s a fund or separate account, we’re really trying to understand the manager, because that’s the most important part. Whether it’s a mutual fund or an SMA, we want to understand the process, the people, the track record. Where there is increased demand for SMAs, is that being driven by advisors or asset managers? It’s probably usually from the advisor, because they’re working with their client, trying to find the best vehicle, the best way to structure the client portfolio. How do you use SMAs? We run a dividend growth SMA internally. If a client has a number of those types of stocks already in their brokerage account, rather than selling all those stocks and investing them in a mutual fund, we’ll incorporate those and manage a more custom, tax-sensitive version of our separate account strategy. Do you offer direct indexed strategies? We don’t do direct indexing at this time. It’s something we’ve looked into because, certainly from a tax perspective, something like that could be beneficial.
Henry Orvin Senior Vice President Mondrian Investment Partners
A brief look at the preferred and capital securities market, the changes wrought by the pandemic and how we plan to move forward.
The case for global preferred and capital securities
Mark A. Lieb
James Hodapp
We recently spoke with Mark Lieb, Founder and CEO and Jim Hodapp, SVP and Portfolio Specialist at Spectrum Asset Management to discuss these important topics and why now might be a good time to consider allocating a portion of your portfolio to this quality, defensive, tax-advantaged asset class. 1. What are preferred and capital securities and why might investors consider them at this time? Preferred securities are a segment of corporate fixed-income securities that are subordinated below senior debt and hold a preferred rank above common stock. The very first being preferred stock. The market has significantly grown and evolved over the years. In addition to traditional preferred stock, the preferred securities universe now includes subordinated debt, junior subordinated debt as well as contingent capital securities (CoCos). The primary issuers are regulated banks, insurance companies, and utilities as well as some telcoms, industrials, REITs, and other corporates. Like bonds and other fixed income securities issued at a par value, holders receive a coupon payment but do not share in the upside net worth growth of the company as do common stock equity holders. There are several similarities and differences between types of securities within the preferred and capital securities universe. For example, both are issued at par value and are subject to a call feature (typically 5- or 10-years from the date of issuance). The call terms can vary; they may be fixed-for-life, fixed-to-float, fixed-to-reset, or floating. Both subordinated and junior subordinated capital securities, which are primarily issued by insurance companies and utilities, are dated with a specified date of maturity and cumulative. The traditional preferreds and CoCos, which are primarily issued by U.S. and non-U.S. banks pursuant to regulatory AT1 Capital rules, are perpetual and non-cumulative. That is, often issuers may defer coupon payments (cumulative) or temporarily eliminate coupon payments (non-cumulative) without accelerating default; provided the issuer has also suspended common stock dividend payment. The preferred and capital securities universe can be referred to as the “Preferred, Hybrid, Subordinated or Capital Securities” market – which all describe the collective market universe. A key takeaway is that these securities are typically issued by well capitalized corporate issuers whose senior debt (enterprise level) is Investment Grade (IG) rated (typically rated A- to BBB+). By going down the capital structure to subordinated securities (typically rated BBB/BB), investors receive a higher yield. The “High Yield” market is different. High yield bonds are below investment grade senior debt at the enterprise level. Our market is the yield pick-up for subordination, the universe of high yield bonds issuers is very different. We believe the market for preferreds and junior subordinated capital securities is strong as the fiscal spending/vaccination/re-opening dynamic continues to foster higher equity valuations and tighter spreads. We expect that demand for subordination premium will continue to be robust given the significant amounts of capital that are looking for returns in a yield starved world. 2. How does Spectrum Asset Management approach investing in this market and could you provide insight into your investment philosophy and process? Spectrum’s investment philosophy is focused on capital preservation, while seeking enhanced yield and moderate capital appreciation resulting from an actively managed portfolio of subordinated securities. From our founding in 1987, Spectrum’s investment process has two distinct drivers: 1) credit quality analysis by the research team and 2) security selection and portfolio construction by portfolio management. The credit research process combines top-down and bottom-up analysis. Top-down is focused on typical global and regional macro-economic and political factors. Bottom-up is focused on specific credit quality fundamentals. In terms of fundamentals, our team employs CAMEL Analysis – looking closely at each issuer in terms of Capital, Asset Quality, Management, Earnings and Liquidity plus ESG. The process is dynamic and ongoing and the team is actively in touch with industry analysts and issuer management. The team continuously updates and maintains internal scores and relative ranking for each of the CAMEL components based on the fundamental attributes. The credit team sets maximum exposure limits for each specific issuer that has been approved based on credit quality. The portfolio management process combines security selection based relative-value analytics along with tactical portfolio construction based upon risk/reward factors which incorporate issuer, security type, industry, and regional diversification as well as establishing portfolio credit, yield and duration targets. While the essence of our investment process has remained steadfast, we continue to adapt and evolve along with the changes in our market. Most importantly, the portfolio management process is supported by state-of-the-art tools to review, monitor, and evaluate relative-values, portfolio characteristics, guidelines, risk, liquidity as well as providing efficient trade processing, attribution analytics, compliance controls. 3. What misconceptions might investors have about preferred and capital securities? The greatest misconception is that the different type of securities and call features can seem complex and confusing at first. Our market falls squarely within the corporate fixed income category – but spans across the traditional demarcation between investment grade (BIG) (e.g., BBB) and the upper-end below-investment-grade (e.g., BB). We have been focused on this market for 40 years and always aim to demystify initial misconceptions that these securities may be too complex or confusing to understand. The fact that we span the IG/BIG credit gap and have a wide-range of security structures is an advantage; providing greater opportunities to derive added-value for our clients. 4. How was this market impacted by Covid-19 – and what portfolio changes did you make? The COVID-19 pandemic has reshaped the world. We firmly believed that financials entered the crisis from a position of strength, despite major uncertainty and headwinds. During the outbreak of the COVID-19 pandemic – the flight to quality impacted both equity and credit markets alike. Credit spreads significantly widened. In short order, investors recognized that bank and insurance company balance sheets were strong, largely due to the regulatory reforms adopted after the Financial Crisis, and accordingly, our market quickly stabilized and recovered. COVID-19 once again showed that our focus on credit research and security selection is very important. 5. What is Spectrum’s outlook for this market over the next few years? Our focus is on the post-COVID-19 recovery and Central Bank policy which will play-out over the next few years. Against the backdrop of an actively intervening U.S. Federal Reserve (Fed) and loose European Central Bank (ECB) monetary conditions, we hold a constructive 2021 outlook for global junior-subordinated capital securities. We are moving toward normalization of the yield curve, which is a positive for the banks and insurance companies alike. Given the range of security structures available in our market – we can be adaptive to market conditions. We can shift duration downward and we are focused on call terms that provide greater yield protection. Investors are searching for yield and we are well positioned. Bottom-line, we believe that our markets have been and will remain attractive. 6. What are the different types of preferred SMAs that are available from Spectrum? Spectrum offers a broad range of products to serve the needs of our clients. In addition to several mutual funds that we manage for U.S. investors and non-U.S. investors, we offer four SMA Models offered via platform wrap-program sponsors. We can also provide customized SMA portfolios for institutional investors. All are managed by the same team and similarly draw upon the firms’ investment process. To learn more about how preferred and capital securities can potentially benefit your portfolio; contact your Principal Global Investors representative.
Founder, President and Chief Executive OfficerSpectrum Asset Management
Senior Vice President and Portfolio Specialist Spectrum Asset Management
This material is provided by and reflects the current views and opinions of Spectrum Asset Management, Inc., an affiliate of Principal Global Investors. Principal Global Investors leads global asset management at Principal®. Spectrum is a leading manager of institutional and retail preferred securities portfolios. Investing involves risk, including possible loss of principal. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Risks of preferred securities differ from risks inherent in other investments. In particular, in a bankruptcy, preferred securities are senior to common stock but subordinate to other corporate debt. This material may contain ‘forward-looking’ information that is not purely historical in nature and may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction © 2021 Principal Financial Services, Inc. Principal, Principal and symbol design, and Principal Financial Group are trademarks and service marks of Principal Financial Services, Inc., a member of the Principal Financial Group. MM12213 | 06/2021 | 1666455-062022
