SMAs versus mutual funds

Which should you use for your financial goals?

Mutual funds have been long been the choice for investors seeking professional money management. When you buy shares of a mutual fund, your assets are pooled with those of other fund shareholders, lowering costs and taking advantage of economies of scale. You gain professional money management, but be aware that a fund manager cannot tailor its portfolio to meet your individual requirements — it’s more one-size-fits-all.

For investors who want or need a more customized approach — for example, in order to better manage tax liability or control individual stock holdings — separately managed accounts (SMAs) have become popular. This is especially true of those investors looking for additional investment categories like real estate, international, or small-company stocks.

What is an SMA?
An SMA is a personal investment account that is customized and managed for you by one or more professional money managers. In an SMA, your assets are not commingled with those of other investors. With a mutual fund, you buy and sell shares of the fund. Even though each fund share represents a proportionate ownership of individual securities within the fund, your share of each of those securities is tiny. By contrast, you are the sole owner of each security within your separately managed account.

How SMAs can be customized for your specific situation
An important feature of SMAs is their ability to allow you to exclude certain securities. You also can set sector guidelines to avoid investing in a sector you might disapprove of (for example, tobacco or casino stocks). This flexibility allows you to better tailor your asset allocation for your own unique circumstances and desires — key considerations for many investors with concentrated stock positions.

Azzad always avoids the types of businesses that profit from unethical businesses like alcohol, tobacco, gambling, or pornography. But clients sometimes elect to remove other companies from their SMAs for various reasons.

However, don’t expect to micromanage every single trade, as you might with a traditional brokerage account. Within the guidelines you set, the money manager typically will have discretion to implement strategies that he or she feels will provide the best returns for you. And you’ll always be able to track what has been bought and sold on your behalf.

How SMAs trump mutual funds on taxes
Mutual funds have an inherent lack of tax efficiency. When you buy shares of a mutual fund, you automatically get a share of its embedded tax liabilities. By law, mutual funds are required to pay out realized capital gains to all fund holders, regardless of how long you have held its shares.

For example, if you buy shares in a mutual fund right before a distribution date, you may receive a distribution and have to pay capital gains taxes even though you may have held the fund for only a short amount of time.

Learn more: Why your mutual fund dropped on a day the market was up

Also, some fund investors can find themselves owing income tax on their fund investment, even though the fund may have declined in value during the year. If a fund manager sells some of a fund’s holdings at a profit but other holdings drop in value, the fund can have a capital gains distribution even though its net asset value is lower.

By contrast, each security held in an SMA has an individual cost basis, which allows you to make specific tax-motivated moves. You can generally request that your manager sell a position with an unrealized loss in order to offset capital gains, thus reducing your income tax liability.

Here’s another example: Let’s say you sold a vacation home at a profit, and now you owe capital gains taxes on that profit. To reduce your tax liability, you instruct your SMA manager to sell part of your position in a stock that has dropped in value. The manager sells enough stock to ensure that the losses on it offset any capital gains taxes you would owe as a result of the real estate sale. With an SMA, you are only liable for tax on gains you actually realize because you own the stocks directly. As a result, managers are able to choose which lots to sell in order to minimize your taxes or engage in tax-loss harvesting.

How SMAs compare with mutual funds on fees
Because of the different ways in which fees for mutual funds and separately managed accounts are calculated, it can be challenging to compare those fees. Generally speaking, the larger your account, the more likely you are to benefit from an SMA. Before investing, ask your financial professional to do an “apples to apples” comparison between SMAs and mutual funds, including total fees and trading costs, to determine which is the better deal in terms of overall costs.

The bottom line
For investors who place a priority on control and tax efficiency and have the necessary capital, an SMA program may make a lot of sense. If you think an SMA could be a good fit for you, we invite you to learn more about separately managed accounts with the Azzad Ethical Wrap Program.

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