Mutual funds, ETFs (exchange-traded funds), and SMAs (separately managed accounts) are three of the most popular types of investment vehicles. Investors are faced with so many options these days that it can be overwhelming and often confusing. Understanding the key differences among these three is important for any investor looking to build a diversified portfolio that caters to their individual situation. Let’s explore the differences, benefits, and drawbacks of each. From there, you can determine which may be the best fit for your situation and preferences.
Mutual Funds
Mutual funds offer several benefits:
Diversification & Factor Investing: Mutual funds combine investments from various individuals and institutions to create a diversified portfolio of stocks, bonds, and other assets. This helps diversify risk and reduces exposure to any individual security’s movements. Many mutual funds also offer factor-specific strategies catered to investors preferences such as value, growth, small-cap, international, ESG, and others.
Liquidity: Mutual funds are often highly liquid, allowing investors to buy or sell at net asset value (NAV) by end-of-day. This makes it possible for investors to access their funds in a timely manner.
Skilled Management: Professional fund managers make investment decisions for investors. They perform research to make sure that the underlying investments align with the fund’s mandate.
However, it’s essential to note that mutual funds also have some potential drawbacks:
Capital Gains: The holdings within mutual funds can generate capital gains, even if the investor does not sell. This can lead to unexpected taxes for mutual fund holders.
Trading at End-of-Day Only: While most mutual funds are liquid, investors can only buy or sell shares in the fund daily at market close. Although this suffices for most investors, the lack of intraday trading can constrain an investor’s ability to respond swiftly to new market events.
Fees: Most mutual funds charge management fees and other expenses, which can impact returns over time.
ETFs (Exchange-Traded Funds)
Exchange-Traded Funds (ETFs) rose to prominence in the 1990s, merging the most desirable attributes of mutual funds with the flexibility of individual stocks. Some advantages include:
Very Liquid: ETFs stand out from mutual funds by being tradable at live market prices throughout the trading day. This feature is beneficial for those engaged in day trading or investors desiring to move in and out of funds quickly and having a constant reading of what the value of their holdings are throughout the day. (The downside is that this could also cause over-trading or panic selling at times.)
Cost Efficiency: Generally, ETFs are associated with lower management fees compared to other investment vehicles, which can contribute to enhanced returns over a long horizon.
Transparency: A majority of ETFs offer daily disclosure of their holdings. This transparency is attractive to investors who take an active role in managing their investments.
Tax Advantages: Due to their structural design, ETFs can provide tax benefits by reducing the distribution of capital gains taxes.
However, ETFs also have some potential drawbacks:
Management Styles: The growing popularity of actively managed ETFs contrasts with passive ETFs that track an index. This may not align with the preferences of those seeking professional investment management. Most ETFs holds hundreds to thousands of individual securities. This may not always be desirable for investors seeking a more customized, focused solution.
Liquidity Inconsistency: Although ETFs typically exhibit high liquidity, some niche or smaller ETFs may experience reduced trading volumes, which could impact their liquidity, and limit an investor’s ability to sell quickly at a reasonable price.
In summary, ETFs represent an advantageous option for investors who prioritize flexibility, transparency, and cost-effectiveness in their investment choices. They are particularly fitting for active traders, investors looking to have live pricing data on their holdings throughout the day, those implementing tactical asset strategies, and investors focusing on specific sectors or asset categories.
SMAs (Separately Managed Accounts)
Which brings us to SMAs. These are a relatively new creation that used to only be available to institutional investors. They’ve recently become available to retail investors at lower minimums. They’ve gained in popularity due to their individualized investment management approach. SMAs allow investors to possess a collection of stocks or bonds rather than a fractional share of a static investment pool.
SMAs are personalized investment portfolios comprising equities, bonds, and other assets, tailored to align with an investor’s unique goals and tastes. They’re created by financial experts mostly for affluent individuals with complex investment needs seeking custom strategies. Investors with large unrealized capital gains, concentrated portfolios, ESG concerns, and high tax brackets are uniquely positioned to benefit from SMAs.
Some investors may want to track an index like the S&P but exclude certain securities or market sectors. Some may want the ability to diversify around a concentrated positions and move out of the position over time in a tax-efficient manner. Others may want to blend certain investment strategies that they believe will outperform. For these investors, an SMA might make sense. It’s a bespoke approach to investing catered to an investor’s unique needs.
The appeal of SMAs is on the rise for several reasons: The investment landscape has evolved since the debut of ETFs in the 90’s. There’s now heightened focus on ESG concerns, there’s a demand for more control, tax-smart strategies, transparency in investments, and a shift toward customization of portfolios.
However, account minimums are typically higher in SMAs than for mutual funds & ETFs. Management fees might be higher but may be negotiable based on account size. In addition, SMAs and are often only accessible through professional investment firms.
Breaking it down, key benefits of SMAs include:
Personalization: SMAs cater to the investor’s specific goals, risk appetite, and preferences.
Direct Ownership: SMA investors hold the actual securities, which aids in precise tax management and personalization.
Expert Oversight: Investors have a say in their investment choices, but professional managers handle the day-to-day portfolio decisions usually assisted by complex algorithms.
Visibility: SMA investors have a clear view of their holdings, ensuring they understand and control their investment mix.
Tax Benefits: The direct ownership model of SMAs can lead to tax efficiencies, such as strategic tax-loss harvesting to optimize after-tax returns. Targeted gains and losses management can reduce tax liabilities.
Potential Cost Savings: The streamlined structure of SMAs might offer cost advantages over mutual funds.
However, SMAs may not be suitable for all; here are some drawbacks:
Higher Entry Thresholds: SMAs often require more substantial initial capital than mutual funds or ETFs, potentially limiting their reach.
Possible Tracking Error: While customization is a benefit of SMAs, excessive alterations can lead to a ‘tracking error,’ indicating a divergence from benchmark returns. This may not be desirable for all investors.
Fees: The bespoke management of SMAs can come with higher fees than those associated with mutual funds or ETFs.
Active Participation: SMAs demand investor engagement, with regular strategy discussions and performance reviews necessary.
In essence, SMAs are a viable option for investors seeking a tailored, tax-efficient approach to managing their wealth and those desiring a high degree of customization.
Which Investment Vehicle Is Best for You?
The three investment vehicles we discussed above come with their own set of positives and negatives. Figuring out which one works best for you will come down to your specific circumstances. Mutual funds offer diversified, professionally managed portfolios perfect for long-term investors seeking a hands-off approach. ETFs provide greater liquidity, ability to trade them throughout the day, and cost efficiency. SMAs offer unique solutions customized to individual investors’ needs. This makes them an attractive option for high-net-worth investors with concentrated positions, large unrealized gains, desiring tax management, and bespoke investment strategies.
In reality, many investors opt to blend these investment vehicles within a diversified portfolio to take advantage of the benefits of each.
As is often said, the way to successfully create an investment portfolio lies in blending your investment choices with your individual financial objectives, tax circumstances, and other factors. This will allow you to build a durable and resilient portfolio that could weather the inevitable market volatility and hold up over the long term.
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