What Is a Separately Managed Account?

Exchange-traded funds (ETFs) and mutual funds are the workhorses of the investment world, pooling assets from countless investors into a single, diversified portfolio of securities. But such funds generally don't offer investors a lot of room to customize or tailor their holdings to suit individual needs.

This represents something of a tradeoff for those with more complex goals. For example, an investor who already has big positions in certain large-cap stocks may struggle to find funds that don't increase their concentration risk by investing in the exact same stocks. Nor can tax-efficiency-focused investors in ETFs and mutual funds harvest losses from individual stocks within those funds for a tax break.

Separately managed accounts (SMAs) can help overcome some of these limitations. Here's how they work.

Like an ETF or a mutual fund, an SMA is a professionally managed portfolio of securities designed to pursue a particular strategy. Some strategies focus on a single asset class, like large-cap stocks or corporate bonds. Others hold multiple asset classes or aim for tax efficiency.

However, where ETF and mutual fund investors own shares of the funds, which in turn own the underlying securities, SMA investors own the securities directly. This allows for a certain amount of personalization that isn't available with funds, as we'll see below.

When you invest in an SMA, you start by picking a particular strategy (e.g., whether you want to focus on a particular stock or bond strategy, or multiple asset classes). The manager can then fine tune the portfolio in line with your preferences regarding any tax sensitivities, your existing holdings, or desires to exclude particular stocks or industries.

Once your account is funded and your portfolio created, your SMA manager will monitor and adjust your holdings as needed. You will be able to track the performance of your SMA alongside your other investment accounts, provided they are held at the same custodial firm.

As mentioned above, the fact that you own the individual assets in the account is what sets SMAs apart from ETFs and mutual funds. Direct ownership can yield:

The asset manager will use your personal preferences to guide the trades within your account. For example, you may be able to exclude certain securities from your portfolio. (Note that there may be limits to how much each portfolio can be personalized, and particular moves will be at the portfolio manager's discretion.) This can help when you have large holdings of employee stock, or you want to avoid a company whose mission doesn't align with your values. In fact, many newer SMAs offer direct-indexing strategies. Direct indexing involves buying most (if not all) of the individual stocks that make up an index, and then adding to, subtracting from, or reweighting components to better align with your investment strategy, needs and tax goals. Here again, there may be limits to how far a portfolio can be adjusted away from the original target.

SMA managers have control over which groups of securities to sell, which can generate substantial tax savings. They can sell positions strategically to harvest capital losses and offset gains in other parts of the portfolio or elsewhere (such as from the sale of real estate or collectibles). The manager can also defer gains or realize them when the investor's tax bracket is lower, such as after a significant business loss. In addition, unlike with mutual funds, SMAs aren't required to distribute capital gains to all shareholders at least once per year, which can help cut down the related taxes.

Investors can monitor their portfolio trades and holdings in real time. Contrast this with mutual funds, which must disclose their holdings only on a monthly or quarterly basis, often with a 30- to 60-day lag. Because an SMA's performance is based solely on the individual investor's holdings, it can be easily tracked. The disclosure of management fees is typically clearer, as well, since they are billed as a separate line item. Mutual funds, by comparison, deduct their expenses from their net asset value throughout the year.

SMAs aren't for everyone. You'll want to consider the following requirements and risks if you're thinking about opening one:

SMA minimums often start at $100,000 for stock-based strategies and can go even higher for fixed income or more complex strategies. You can fund your account with existing securities, but they may be sold and replaced with more suitable investments, creating potential tax consequences.

Customization comes at a price. Because SMAs offer opportunities to fine-tune in line with an investor's preferences, the fees—typically a percentage of assets under management—may be higher than those on a typical actively managed mutual fund. 

That said, what you ultimately pay will depend on which type of account you open:

• A discretionary SMA tends to cost more because the manager has the authority to make day-to-day investment decisions and changes in line with your IPS without seeking prior approval, saving you time and effort.
• A nondiscretionary SMA often is less expensive but requires your explicit approval for each investment change or transaction, requiring more time and effort on your part.

The investment strategy you choose will also affect the cost, with managers tending to charge more for equity-based strategies—which require daily monitoring—than for fixed income-based strategies. Most managers offer fee discounts for larger account balances.

As is the case with ETFs and mutual funds, your account's performance will depend on current market conditions—as well as the manager's ability to navigate them. You may also face operational, execution, and compliance risks if your manager lacks the requisite experience and scale to manage these risks effectively. Conducting thorough due diligence when picking a manager—looking at performance over multiple time-periods, manager tenure and stability, and more—is paramount.

If you're looking for more control than other pooled investment options can provide, you might consider looking at SMAs.

Whether an SMA is ultimately worth it depends on your personal situation, so be sure to discuss your needs with your financial consultant or wealth advisor, who can also help you select the best manager for your goals.