ETF vs. SMA: Which is Right for You?

The financial industry never stops evolving. In the ‘70s, mutual funds boomed. In the ‘90s, exchange-traded funds (ETFs) were launched. In the 2000s, online investing took off. Today, separately managed accounts (SMAs) are on the rise.¹

What’s the point? Investors are faced with many new and old investment options, making the choice more difficult and often confusing. We’re here to clear up the confusion, starting with the differences between an ETF and a separately managed account (SMA).

Why are SMAs gaining popularity?

When ETFs were introduced in 1993, they were indeed a “revolutionary” way to purchase a pooled investment of stocks. But that was nearly 30 years ago.

It’s a new world now. The economy and environment are different. Millennials are investing more. Other investors are a generation older and wiser. Today, environmental, social, and governance (ESG) issues are a big deal, and investors want new levels of flexibility, tax efficiency, transparency, convenience, and low costs to achieve their goals.

In this environment, it’s no surprise that separately managed accounts are growing in popularity.

What’s different about SMAs?

Have you ever bought shares of a particular company, like Microsoft or GE⁺, in a brokerage account? Or maybe U.S. treasury bonds? If so, you created a mini separate account that you controlled.

A separate account managed by a professional is similar yet has a distinct difference; Instead of buying stocks and bonds on your own, an investment manager buys individual stocks (or bonds) in an account just for you. There is a strategy behind the types of stocks or bonds purchased—it’s based on your personal investment goals, such as when you want to retire, how much risk you can tolerate, and how long you want your funds to last, among others. So instead of haphazardly investing in the hottest stocks (we’ve all done that and hit some one-off winners, too), you could own a well-constructed portfolio that fits your needs.

Why don’t you just invest in an ETF or mutual fund?

Because with these pooled vehicles, where your money is invested together with others, you have no control over which securities you hold, when others decide to invest more (hint: it’s usually at the top of the market) or sell out (hint: it’s usually at the bottom of the market which can diminish the returns of everyone in the pool), or if (or when) you receive taxable distributions. And with a pooled investment, you own a slice of a fund—you don’t individually own any stock or bond.

An SMA gives you more control to invest in a way that’s right for you. So instead of holding a tiny slice of a fixed ETF pool of investments, you hold a bundle of stocks designed to work together.

Active or passive management: Which approach do you favor?

Many ETFs are designed to track an index, so these do not have active managers who transact holdings, except in the rare times when the index rebalances. The main benefit of this passive management style is its low cost and, for some, knowing that their performance should be about equal to the tracked index.

But the downside (for some investors) is that there is no manager discriminating between perceived terrible companies and high-quality ones. While active management cannot always improve performance over passive management, at least there is the opportunity to do so, which many investors appreciate, especially in down markets. 

By contrast, SMAs are actively managed. This means that the investment managers may decide to invest in new or cull old securities, or add or trim positions around the margin to improve performance.  This approach is favored by investors who seek the opportunity for better than market returns.

How do SMAs compare to ETFs on flexibility?

Instead of owning an inflexible fixed slice of a fund, an SMA accountholder owns individual stocks. Most separately managed accounts start with a specific portfolio based on the individual’s risk/return needs and time horizon. Then, if a particular holding doesn’t fit an investor’s personal beliefs—for any reason—the manager can remove it from the personal account. The manager will seek to replace it with a similar investment to maintain the original balance between risk and return. If a similar investment cannot be identified, the investor may hold cash or a basket of names that mimic the market instead.

This is a defining characteristic of an SMA, but it doesn’t come without warning—if too many customizations are made within a particular strategy, the performance will likely deviate significantly from a model portfolio’s returns the investor may expect.

What about the impact of taxes?

Every type of investment is subject to capital gains tax and tax on dividends or distributions. But some vehicles can lower the taxable burden through their structure. For example, ETFs are more tax efficient than mutual funds because they use creation units for the purchase and sale of assets in the fund. This tends to create fewer capital gains than mutual funds, which buy and sell individual securities.

Similarly, SMAs transact individual securities. But managers also have the ability to offset some gains with losses, thus minimizing overall taxes. SMAs also tend to hold fewer securities than pooled vehicles, so they may transact less frequently than other actively managed funds.

But ETFs are less risky, right?

Because ETFs often hold hundreds of stocks, while SMAs hold far fewer, many investors believe they are less risky. But research shows that you only need to hold 20-40 stocks to diversify 80% to 90% of portfolio risk.² This is a case where more isn’t necessarily better!

Another benefit of an SMA over owning several ETFs is portfolio construction. Because one manager (or management team) is responsible for constructing your account, they can potentially put better risk controls in place.

Take this asset allocation, for example: A portfolio consisting of 31% U.S. large-cap growth stocks, 17% U.S. small/mid caps, 20% international, and 32% corporate bonds.

In an SMA, the manager can calculate the historical volatility—measured by standard deviation, which tells the investor how much the expected returns may deviate from the average return. In this example, it’s 12.2%.* And, importantly, the manager can look at the relationship among the holdings—from cash flows to profits—to understand how well the securities fit together in a portfolio.

Source: Motley Fool Wealth Management (MFWM), Jul. 25, 2022. Calculations are based on expected returns of model portfolios managed by MFWM. Dispersion of returns is the volatility or standard deviation of returns from the average return.

The calculation is less precise with a basket of ETFs. You could take the standard deviation of each fund to calculate the weighted-average standard deviation to get a volatility measure—it's annoying but can be done.

But you don’t get an understanding of the interplay among all the holdings and the potential overlap of names in the various ETFs. (You’d be surprised how one company can be both growth and value, mid and large cap, and perhaps both U.S. and international—if a lot of its revenues come from overseas!) That could mean a lot of unexpected and unintended exposure to one stock.

ETFs do tend to have a noticeable benefit, though

There are a few truisms regarding fees for managed investments. First, passive funds tend to be cheaper than active ones. Second, pooled vehicles tend to be less expensive than SMAs.

Generally, SMAs charge a management fee of about 1% per year. The expense ratios for active ETFs and mutual funds can also be around that level depending on the securities they invest in (more niche funds tend to have higher fees). But on average, the annual expense ratio for an actively managed ETF is 0.69%.³ On the lower end of the spectrum, passively managed ETFs come with low expense ratios, averaging 0.18% per year.⁴

It’s a personal choice

ETFs are growing in popularity. And so are SMAs. Which is right for you? It depends on your wealth goals. But we think the flexibility, potential to earn above-market returns (over a passive fund), and relative concentration (while still being diversified) offered by SMAs suit the needs and interests of many investors. Other considerations include leaving a legacy, making charitable donations, and switching among strategies as circumstances change without potentially having to sell out completely. An SMA can do all those too.

Not sure how to proceed? A Wealth Advisor can help you figure out your best course of action.