Tax-Managed Separate Accounts, Explained

As high interest rates linger, investors are on the hunt for income opportunities. Investors have flocked to fixed-income separate accounts for the promise of personalized portfolios and tax management savvy. Cerulli reports that advisors expect allocations to separate accounts to increase from about 8% to close to 10% by 2025.

When are SMAs right for investors? How should investors think about the value of tax efficiency?

Jason Diefenthaler is the head of tax-exempt strategies at Schwab Asset Management. He joins the Big Picture in Practice podcast to detangle the world of the tax-managed fixed-income.

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Separate accounts are personalized investment accounts overseen by professional portfolio managers on behalf of investors. SMA investors directly own the underlying securities in their portfolios, unlike mutual funds and ETFs, giving them more control. Because of their high-touch management, SMAs often come with higher account minimums.

Fixed-income SMAs can have a tax advantage over mutual funds in a few ways:

• Capital gains distributions. Mutual funds must distribute all their capital gains each year, which means that investors are stuck with the tax liabilities even if they don't sell their shares. In contrast, investors in SMAs don't realize capital gains on individual securities until they sell them, allowing them to defer taxes and potentially compound investments at a higher after-tax rate.

• Tax-loss harvesting opportunities. SMAs offer more flexibility and control over the investment portfolio, allowing investors more options to reduce tax costs. Managers can sell off individual positions to realize losses, unlike in a mutual fund, where you would have to sell off the whole thing.
• Investment selection by location. The interest paid on municipal bonds is usually exempt from federal income taxes. Depending on the type of bond and where investors live, that interest may also be exempt from state and local taxes.

Since its acquisition by Schwab four years ago, Wasmer Schroeder Strategies have grown 23% on a compound annual basis. Year to date, the firm has four billion in net inflows.

The team offers fixed-income strategies across a wide range of duration, credit, and tax efficiency. Their tax-exempt SMAs fall into two categories:

• Actively managed funds where portfolio managers adjust holdings on behalf of investors.
• Bond ladders seek to minimize interest-rate risks with staggered maturity dates.

Jason says the firm serves clients of all types, with over 27,000 individual accounts. In addition to working directly with Schwab investors, the firm also has third-party relationships with:

• Wirehouse platforms.
• Turnkey asset management platforms.
• Family offices.
• RIAs.

Individual investors can have vastly different needs than an institutional client, like a bank or insurance company. They come to the table with different levels of risk tolerance, income needs, tax sensitivities, and time horizons.

“All these factors are relevant, and in fact, critical, when clients are making decisions about selecting a strategy to meet their needs,” Jason says. “It's very important to bring a menu of separate account solutions to the table upfront to help our clients make those appropriate strategy choices.”

Jason explains what fixed-income portfolio managers do behind the scenes to hone tax efficiency.

Minimize taxable capital gains. Portfolio turnover measures a fund’s trading activity. The lower the turnover ratio, the lower the transaction costs and capital gains distributions. Managers must make strategic decisions about when trading adds value and when it doesn’t.

Tax-loss harvesting. Managers offset gains by selling investments that have experienced losses. But too-frequent trades come with trade-offs in the form of transaction costs. Managers have to make judicious decisions about when tax-loss harvesting adds value.

Maintain portfolios. In fixed income, “every day brings a decline in portfolio duration,” Jason notes. As portfolios age, managers must proactively execute swaps to meet active duration targets. “If we’re off target on something as important as a portfolio duration, the client’s outcomes aren't going to measure up to their expectation,” he says.

Tailor accounts to clients. Jason’s team manages portfolios for clients across the country. They must account for a client’s state of residence and state income tax rates as they assess risk-return tradeoffs of muni bonds.

Reinvest cash flows and deposits.

Raise cash on demand for clients as they need it.

“We want to understand why we performed the way we did, how our benchmarks performed, what worked, what didn't,” he explains. “Ideally, we’re learning from that with each day that passes.”

One of the biggest responsibilities of portfolio managers happens outside of the portfolio.

Jason’s team regularly meets with clients to stay on top of any changing life circumstances and to present performance updates in context. The economic benefits of tax-managed investing won’t necessarily appear in absolute returns.

Advisors and portfolio managers present tax-adjusted performance numbers that answer more nuanced questions. How much did tax-loss harvesting cost in transaction fees? How much did clients avoid in tax dollars? How does one account compare to another following the same strategy?

“Standard performance measurements simply won't capture those nuances,” Jason says.

For example, take a client in California.

A Californian in the max state income tax bracket may choose an all in-state portfolio over a national approach to take advantage of the state tax savings. However, California bonds typically yield less than bonds issued in other states. That client should reasonably expect some degree of absolute underperformance compared to a national portfolio. But the goal would be to outperform a national portfolio in relative terms.

“It's important to work with the client so they understand what they’re looking to accomplish and to make clear determinations about the actual economic benefits of any tax-driven trading,” Jason says.

Today, Wasmer Schroeder manages over 40 investment strategies. Jason’s team closely follows the performance dispersion of each strategy, making sure that all the accounts perform in a similar fashion.

“If we're working with an investment advisor that has 50 clients in the same strategy with us, we want to make sure that all of those clients perform within a very tight range for that advisor,” he says.

One of the main appeals of separate accounts is the opportunity for personalization. Investors want portfolios built for their goals, their needs, and their time horizon. But the more individual accounts the firm runs, the more the team spreads across high-touch accounts.

To walk the tightrope of scale and customization, Jason says that the team focuses on consistent, repeatable processes to manage the “sheer volume of accounts.”

“As an investment manager, we're focused on delivering that personalized experience with the goal of meeting our clients’ expectations, while also allowing for the greatest level of business efficiency,” Jason says. “An efficiently run investment management process is highly correlated to positive client outcomes.”

They need to adapt to some customer needs, while having a limited enough menu that they can continue to maintain their options.