Model Portfolio & SMA Strategists Showcase - Flipbook - Page 31
SMAs & MODEL PORTFOLIOS
THE TURNOVER AND TAX-DRAG
DIMENSION
Performance evaluation for a taxable
client can’t stop at pre-tax returns, and
this is where SMA composite reporting
gets particularly slippery. A strategy with
strong pre-tax alpha but high turnover
can lose much of that advantage, or
turn it negative, once realized capital
gains taxes are factored in for a taxable
account. This dynamic, examined by
Jeffrey and Arnott’s now-foundational
research on the tax cost of active
management, is precisely why turnover
and portfolio name count matter as much
as headline return when evaluating a
strategy for a taxable client.
Portfolios with more securities and
lower turnover generally provide
more flexibility for the kind of active
tax management covered in depth in
the next section, while high-turnover,
concentrated strategies tend to
generate the largest gap between pretax and after-tax outcomes.
A WORKING RULE FOR READING
ANY PERFORMANCE PACKET
Ask, specifically, whether this is a live
composite of actual client accounts
or a theoretical or model account.
What’s the benchmark, and does
it genuinely match the strategy’s
risk profile? What’s the drawdown
and standard deviation alongside
the headline return? And what’s the
turnover, and has anyone modeled the
after-tax version of this return series for
a taxable account? A provider that can
answer all four cleanly has done real
work to earn the performance claim.
A provider whose materials only
answer the first, the headline return,
hasn’t yet given an advisor enough to
make a defensible recommendation,
no matter how good that headline
number looks.
Direct Indexing &
Tax-Managed SMAs
E
verything covered so far,
structure, marketplaces, overlay
management, due diligence, and
strategy evaluation, sets up the chapter
where SMAs make their strongest,
most differentiated case relative to
funds: taxes. For a taxable client, the
after-tax return is the only return that
matters, and direct ownership is the
single structural feature that lets a
manager actively work that number in
the client’s favor.
(This chapter focuses on equity direct
indexing specifically. For fixed-income
tax management, municipal bond
SMAs and laddering, see the strategytypes chapter, p. 27.)
The category has a specific origin point
worth knowing. Parametric Portfolio
Associates built its first custom
portfolio in 1992, designed to behave
like an index while keeping a watchful
eye on tax management, a strategy
the firm itself describes as the seed
from which direct indexing eventually
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grew. What’s now a multi-hundredbillion-dollar category across dozens of
providers started as one firm’s attempt
to give an index-like holding the tax
flexibility a fund could never offer.
THE BASIC MECHANISM
Direct indexing means owning
a diversified basket of individual
securities designed to track an index,
rather than owning shares of a fund
that itself holds the index. Rather than
owning the market wrapped in an ETF
BY THE NUMBERS
$500 billion, +67% in
two years
Tax-managed SMA assets have surged
past $500 billion, and direct indexing
overall is projected to reach roughly
$825 billion by the end of 2026. This
isn’t a boutique tax strategy anymore. It’s
one of the fastest-growing segments in
the entire managed-account industry.
