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Tax Efficiency and Investing What You Need to Know About Index SMAs


As the aggregate size of an investor’s portfolio increases – to say nothing of an investor’s annual income – it’s in the investor’s best interest to investigate ways in which to improve tax efficiency, and reduce tax liability as much as possible to help maximize returns.
This article will discuss several tactics related to tax efficiency as it concerns index SMAs, as well as offer a few tax avoidance strategies that SMA holders may want to consider utilizing. Read on to learn more.

What is an SMA?

The term “SMA” refers to a Separately-Managed Account. Investors can be categorized as “retail” or “institutional” investors, with strategic management for institutions requiring minimum investments of $25 million or more. Retail-class mutual funds and products obviously don’t require the same level of financial commitment.

Created initially as an alternative to mutual funds, SMAs were constructed for investors within the highest tax brackets – those who want to invest as individuals but have investment capital nearly approximating the institutional benchmark.

It might be best to think of an SMA as a mutual fund designed specifically for one investor, collecting a diverse basket of equities and requiring active management by an investment firm.

Due to the money involved – which again can be just below the $25 million-dollar institutional mark – SMAs often include multiple managers as well as a full team of analysts and support staff.

SMAs have much more in common with a large corporate account than most individual mutual fund accounts, which in most cases can easily be serviced by a single manager.

In fact, one of the most appealing aspect of mutual fund or index mutual fund is that management and account fees are relatively low. Given the money and staff involved, fees for SMAs can be notably higher.

What is an Index SMA?

An Index SMA provides many of the benefits of a traditional SMA while attempting to mitigate some of the primary risks associated with index funds.

Proponents of index funds and other forms of passive investment tout how relatively easy they are to manage and monitor, but any type of mutual fund comes with a specific litany of risks that need to be mitigated or accounted for.

To cite a single example, the overall rise in index fund investment has led to valuation distortion of many small and mid-cap companies. Numerous investors have noted that almost one-third of all stocks in the Russell 2000 are in the red, and index funds force investors to take on these albatrosses.

Some of these smaller companies with a certain index might be drowning in debt and barely breaking even, but the overall rise of a given index leads unobservant investors to believe that all of stocks within an index are solvent, if not quite profitable.

By buying into a index mutual fund, an investor is forced to take stock in non-profitable companies and lacks the flexibility to shed them. With the dollars that a high-bracket investor could potentially place into an account, he or she will want to hand-select all of the constituent equities within an Index SMA.

In an index SMA, the investor directly owns the individual stocks in their account, and every security has a cost basis consistent with the investor’s investment horizon.

Why Improve Tax Efficiency?

Tax efficiency is simply reducing potential tax liability whenever possible. No one wants to pay higher taxes than they potentially owe, and investors with robust and varied portfolios will want to use a number of different tax avoidance strategies in order to improve overall tax efficiency.

As mentioned above, cost basis is alternately known as tax basis, and is important for investors who ordinarily reinvest dividends (rather than taking payouts) to understand.

If an investor puts her or his distributions back into the investment, the tax or cost basis of an investment goes up. The first of several tax avoidance strategies that an investor should integrate is accounting for this increase and reporting a lesser capital gain. This leads to lower taxes owed and more take-home.

Investors who fail to make this adjustment could end up paying double the taxes – twice on the same dividend reinvestment. Obviously, no investor would want to do this.
In short, investors who do not account for cost basis can potentially incur unnecessarily-high, undue tax liability. Given the potential dollars involved in an index SMA – often in the millions – this figure could be significant.

So, it behooves any investor – but especially an investor playing at the SMA level – to look for ways to improve tax efficiency, and implement a number of tax avoidance strategies in order to increase yield.

Efficiency within Index SMAs

Index SMAs also can be efficient in that they have the ability to preserve qualified dividends. In this situation, the dividend is taxed according to the capital gains rate, which could be considerably lower than the income tax rate for a high-bracket investor.

Qualified dividends are currently capped at a tax rate of 20%. A high-bracket investor could be paying nearly double that figure in standard income tax. So, this is one way in which a large-money investor could improve tax efficiency and effectively use some tax avoidance strategies.

The difference between a qualified and non-qualified dividend matters, as non-qualified dividends are taxed as income while qualified dividends are capped at 20%. To maintain a qualified dividend, a fund must hold a security at least 60 days prior to its ex-dividend date.

Funds may sell securities within this period in order to maintain a mandated tracking error against the benchmark. This is a way in which an index SMA is more flexible than an index mutual fund or an ETF.

Many index products do not consider the holding periods or tax status of the investments they hold. This means that investors could be subject to a much-higher tax bill than they would with a more tax-aware strategy.

Active management, and the intense servicing that goes into an index SMA, is highly aware of potential high-tax situations, and will work to avoid them at all costs. An active interest in the holdings and a hands-on approach, in and of themselves, are two more of the best tax avoidance strategies.

Other Tax Avoidance Strategies to Implement

Index SMAs offer a number of tax-reducing options that ETFs and index funds do not. While both ETFs and index funds can offer some upfront returns – in large part due to minimal management fees – index SMAs are often superior when tax-time comes around.

Security Harvesting

Index SMAs have the ability to provide sizable tax-loss harvesting to taxable investors who have substantial portfolios with the possibility to provide higher after-tax returns.

SMA holders are able to realize (or “harvest”) a loss, somewhat or completely mitigating taxes on both gains and income.

The securities sold or “harvested” are replaced in the index SMA by comparable securities. This keeps the overall returns consistent and the index diversified optimally.

Because ETFs and index funds usually don’t let investors cherry-pick which securities are held in or removed from the fund, this is one way in which holding an index SMA is advantageous.


As noted above, index SMAs offer flexibility and customization with factor options beyond what an ETF can achieve.

Again, ETFs are constructed with the collective in mind, and do not take into account the specific situation of a high-tax bracket investor.

To cite potential unwanted tax liability from an ETF that an index SMA investor could avoid, an ETF would likely include some investment in gold – which is viewed by the federal government as a collectible and taxed at 28%. The same issue occurs with currencies, which are also apt to be held in an ETF.

An index SMA holder could of course remove gold and/or currencies from their portfolio, lowering their total tax liability. 28% liability might seem palatable for some investors, but if the given investment is an index SMA worth $20 million, 28% taxation on a key stock within the portfolio could be a significant number.

While ETFs remain a better choice for smaller investors or for tax-exempt accounts with no customization needs, the tax-loss harvesting and customization advantages of SMAs provide an index strategy that may provide performance beyond that of a traditional index fund.


One tactic an investor may not know is that highly-appreciated individual securities found within an index SMA can be gifted to charitable institutions. This tactic can reduce an investor’s tax bill while also helping out a good cause.

Gifting with index funds or ETFs occurs at the share level, so an index-fund investor will likely not realize the same tax benefit that an index SMA investor would. This makes donating extra appealing for those in higher tax brackets.

Investors can further investigate charitable donations, and see which individual securities within their index SMA might be worth parting with.

As far as tax avoidance strategies go, this is one of the most mutually-advantageous – to both the investor and charity of choice – tactics that an investor could implement.

Tax Avoidance Strategies to Help Maximize Returns on an Index SMA

All things considered, an index SMA can be a viable alternative to funds and ETFs – especially for those looking for additional avenues to effectively implement their tax avoidance strategies.

Investors can and have used index SMAs to reap significant returns, provided the investors and their managers do proper diligence and limit tax liability whenever possible.


Linden Thomas and Company and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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