Investing your money wisely is crucial for securing your financial future. When navigating the investment landscape, you’ll encounter various options, and understanding the nuances between them is key to making informed decisions. Among the popular choices are mutual funds, exchange-traded funds (ETFs), and separately managed accounts (SMAs). Each of these investment vehicles possesses distinct characteristics, and determining the most suitable one for your needs can be challenging.
To simplify this comparison, we’ll evaluate mutual funds, ETFs, and SMAs based on six critical investment criteria. For each criterion, we will identify which investment type emerges as the winner, offering a clear picture to aid your investment choices.
Criteria #1: Tax Efficiency – Mutual Funds and Embedded Capital Gains
Mutual funds can present a tax inefficiency known as the embedded capital gains problem. This issue arises from the fund’s structure where you own shares of the fund, not the underlying securities directly. Consequently, the cost basis for tax purposes is tied to when the fund purchased the securities, not when you invested in the fund.
Consider this scenario: You purchase shares in a mutual fund holding XYZ stock, currently valued at $100. Shortly after, XYZ stock drops to $80. If the fund decides to sell XYZ, it might incur capital gains tax because it may have bought XYZ at $50 previously. Even though your fund’s value has decreased, you, as a shareholder, bear a portion of this tax burden. This situation can feel unfair as you’re taxed on gains you didn’t personally realize.
While ETFs can also experience some tax inefficiency if portfolio adjustments lead to capital gains, these instances are generally less frequent and smaller compared to mutual funds. SMAs, on the other hand, offer a way to completely bypass embedded capital gains. With SMAs, you directly own the securities, and your cost basis is determined by your purchase date and price.
The winner for tax efficiency: Separately Managed Accounts (SMAs)
Criteria #2: Tax Loss Harvesting on Individual Securities – Maximizing Tax Benefits
Tax loss harvesting is a valuable strategy to reduce your tax liability. It involves selling investments at a loss to offset capital gains and potentially reduce your taxable income. However, mutual funds and ETFs restrict this strategy on individual securities due to their bundled nature. If a stock like ABC within a mutual fund or ETF performs poorly, you cannot isolate and sell ABC specifically for tax loss harvesting.
In contrast, SMAs provide the flexibility to tax loss harvest at the individual security level. Because you directly own the securities in an SMA, you can strategically sell underperforming assets like stock ABC to realize losses and leverage those for tax savings.
The winner for tax loss harvesting: Separately Managed Accounts (SMAs)
Criteria #3: Hidden Costs from Commingled Investors – Transparency in Fees
Investing in mutual funds means becoming a commingled investor. You are pooled with numerous other investors, and the fund manages securities on behalf of everyone. This commingling can lead to hidden costs. When other investors trade fund shares (buying or redeeming), the mutual fund often needs to execute trades to accommodate these transactions. These trades incur brokerage commissions, which are shared by all fund owners, including you, even if these trades are not directly related to your investment decisions. These hidden costs can erode your returns without you being fully aware.
ETFs and SMAs largely avoid these hidden costs associated with commingled investing. Trading costs in ETFs and SMAs are typically incurred only when transactions are made directly for your portfolio.
The co-winners for minimizing hidden costs: Separately Managed Accounts (SMAs) and Exchange Traded Funds (ETFs)
Criteria #4: Outperformance Potential – Beating the Market
Extensive research indicates that mutual funds often struggle to outperform market benchmarks. Several factors contribute to this underperformance, including over-diversification, conflicts of interest within fund management, institutional pressures, and the aforementioned hidden costs. The disappointing performance is a significant driver for investors shifting from mutual funds to ETFs.
However, it’s crucial to recognize that ETFs are frequently designed to track specific market indexes. This index-tracking nature makes outperformance by design unlikely. For example, an S&P 500 ETF aims to mirror, not exceed, the S&P 500’s performance. Interestingly, some data even suggests that ETFs can underperform their benchmarks due to tracking errors and other factors.
SMAs offer a greater potential for outperformance. Professionally managed and free from many hidden costs inherent in mutual funds, SMAs have the capacity to potentially surpass benchmarks. Historically, wealthy and institutional investors have utilized SMAs to seek superior investment returns.
The winner for outperformance potential: Separately Managed Accounts (SMAs)
Criteria #5: Questionable Behavior – Transparency and Ethical Practices
The competitive nature of the mutual fund industry, with numerous funds vying for investor capital, can unfortunately lead to questionable practices. Mutual funds might engage in behaviors that prioritize attracting investments over acting solely in investors’ best interests.
One such practice is “incubation,” where fund companies launch multiple portfolios secretly, promote only the best performers after a period, and discard the rest. This creates a misleading impression of skill, while often the outperformance is simply statistical chance. “Window dressing” is another concern, where funds manipulate their reported holdings before quarter-end by buying recent top-performing stocks and selling underperformers to create a falsely positive image of their stock picking abilities.
There is limited evidence suggesting that ETFs or SMAs managers engage in these types of questionable behaviors, possibly due to their different structures and greater transparency.
The co-winners for minimizing questionable behavior: Separately Managed Accounts (SMAs) and Exchange Traded Funds (ETFs)
Criteria #6: Ethical and Moral Investing – Aligning Investments with Values
Many investors desire their investments to align with their personal values and ethical beliefs. This might involve excluding companies involved in industries like alcohol or tobacco. Mutual funds and ETFs, being bundled investments, generally do not allow for such specific exclusions based on ethical or moral considerations. You typically invest in the fund’s overall strategy, which may include companies you’d rather avoid.
SMAs offer portfolio customization that caters to value-based investing. SMA investors can often request the exclusion of specific sectors or companies, allowing for portfolios tailored to their ethical and moral principles.
The winner for ethical and moral investing: Separately Managed Accounts (SMAs)
Conclusion: Considering Alternatives to Mutual Funds in the 21st Century
In today’s investment landscape, relying solely on mutual funds may be an outdated approach. Historically, SMAs were exclusive to the ultra-wealthy. However, access to SMAs has become increasingly democratized in the 21st century.
If you are currently invested in mutual funds or considering investment options, it’s prudent to explore SMAs as a viable alternative. Consult with your financial advisor about the potential benefits of SMAs and whether they align with your investment goals. If your current advisor cannot provide access to SMAs, seeking advisors who can may be a worthwhile step to take control of your financial future and potentially invest like institutional investors and high-net-worth individuals.
