PortfolioConstruction Forum asked the research houses: What are the pros and cons of using an Australian equity separately managed account? Under what circumstances would it be appropriate?
Separately managed accounts (SMAs) provide investors with exposure to a professionally managed portfolio of stocks – but unlike a pooled managed fund structure, beneficial ownership of the underlying stocks rests with the investor, and this is one of the key attractions of the SMA structure.
SMAs also offer the potential for a better after-tax outcome, as the structure will generally allow for management of tax parcels. An SMA will also provide investors with full transparency of security holdings.
However, it’s important to be aware that the performance of SMAs managed by well-known fund managers may differ from their pooled managed fund vehicle.
This can result from differences in mandates and portfolio composition, timing and the SMA structure not catering for all corporate actions (such as institutional placements), and these can be a source of value add.
There has been a steady growth in SMA providers of two types. The first can be described as a dedicated SMA manager, while in another group are the fund managers that have extended their offering via a SMA structure.
There are currently some well-known fund managers in the second category: of course, a key consideration for them is whether they are giving away their intellectual property and whether they are cannibalising their existing managed fund business.
Ultimately, each investor needs to weigh up the pros and cons of using a SMA for their circumstances.
We have found that the take-up of SMAs has generally been by those investors who are seeking a direct equity-style solution via a product rather than a service (IMAs, MDAs).
SMAs have been gaining traction in the Australian market. A number of providers are now in the market, and efficiencies from technology are resulting in lower minimum investment requirements.
The main advantages of investing in a SMA are:
- Professional management of an equities portfolio;
- Transparency and portability of the portfolio;
- Beneficial ownership of the securities is with the investor, who gains tax advantages associated with holding directly;
- Where model portfolios are available, investors can customise their portfolio (however, the variety of equity SMA strategies is still quite limited); and,
- Consolidated reporting.
Disadvantages of the structure include:
- The investor is unable to direct the manager to customise the securities selection in the portfolio (although some providers may allow an investor to filter certain securities);
- The model portfolio is already constructed before investing, hence performance of portfolio may suffer or capital may erode if existing securities have already realised their growth potential;
- There is difficulty gaining adequate diversification across good quality managers, especially on smaller SMA platforms;
- Execution risk: i.e, delays in manager decisions being implemented on a timely basis within the model portfolios;
- Portfolio drift, causing the portfolio to differ from the model portfolio.
If an investor is looking to gain exposure to Australian shares directly within their portfolio, then a SMA would be a better approach, particularly in volatile markets.
While the investment costs may be higher compared to other options, Mercer would expect a highly rated manager to exceed benchmark returns, compensating for the higher fees and creating greater wealth for the investor.
However, unless an investor has adequate funds to diversify across a number of managers, then other options to implement their Australian shares exposure should be considered.
SMAs have been available in
SMAs are often misunderstood in the context of how they can potentially improve business efficiency.
Not all SMAs are created equal, and not all purporting to be SMA solutions offer the same level of efficiency and scalability that will improve business work flows, ultimately allowing the adviser to manage and advise on a larger client base with fewer resources (specifically back-office related).
The advantages of using an Australian equity SMA portfolio over a unitised fund with a comparable investment strategy are numerous. Typically, these relate to tax efficiency and transparency.
However, there is also an argument that SMAs should be a cheaper option than managed funds, although it is still too early to gauge, given a sparse universe of professional fund managers offering both an SMA and fund version of the same investment style.
In addition, the fact that SMA portfolios effectively eliminate one layer of costs (i.e, unit trust administration) is in all likelihood counterbalanced by the fact that large, well-established fund managers with scale are much more likely to enjoy economies of scale within their own businesses than smaller boutique SMA managers.
Additionally, because investors personally own the shares in their portfolio, they have their own tax history that is not shared with all investors, as is the case in a unitised fund or trust.
At the end of the financial year, modern day SMA services typically allow advisers and investors an opportunity to select an appropriate tax accounting methodology to optimise the after-tax outcome to the investor.
A common criticism of managed funds is the fact that they lack transparency, with many fund managers fiercely protective of their intellectual property and unwilling to divulge detailed portfolio holdings to the market.
There is a growing legion of more than 50 small- and mid-tier boutique managers who happily embrace transparency, particularly if it provides them with an attractive new distribution channel unencumbered by a complex system of rebates and commissions.
A SMA also provides advisers and research providers with a tool to manage any style of bias in a multi-manager SMA portfolio.
The flip side of SMA transparency is that it can also be a disadvantage for those advisers who tend to support the more well-known managers in Australia, rather than the largely boutique managers occupying the SMA space.
As SMAs are still a relatively new feature of investment landscape, and still well behind managed funds, there is a current lack of an identifiable track record for many.
SMAs are also typically only available in Australian equities. Our local market has a number of biases (resources and banks) and a lack of diversification in a number of sectors, so investors need to be wary of investing all their money into a domestic equity SMA.
A SMA provides an alternative ‘access mechanism’ to the investment decisions of an investment manager.
In essence, a SMA has the potential to deliver a superior after-costs and after-tax performance outcome for the investor.
With a SMA, the investor holds beneficial ownership of the underlying equities (compared to owning units as is the case with traditional managed funds), which delivers a number of benefits relative to managed funds:
- it provides portfolio transparency
- real-time reporting, and
- the ability to forecast and draw down dividend payments from the constituent stocks.
Additionally, SMAs are tax efficient.
When an investor invests in an SMA, the constituent stocks are purchased at that time, compared to a managed fund where the constituent stocks may have been held for a period and may have embedded capital gains that the new investor has not benefited from.
Yet the subsequent sale of shares by the manager may crystalise a capital gain, thereby creating an after-tax cost to all investors.
Finally, the fees and transaction costs of a SMA are generally lower than the equivalent mandate in the form of a managed fund.
In S&P’s view, the only material negative risk of an SMA is that the execution of trades may lag the investment decisions of the fund manager. This is only a risk when the SMA mirrors an existing unit trust.
However, based on S&P's analysis of SMA performance versus their associated unit trusts, the actual performance differences have generally been negligible.
Further, the SMA universe domestically is currently restricted and limited. The sector continues to be characterised by concentrated, low turnover portfolios with predominantly large- to mid-market capitalisation stocks.
This is partly a reflection of investor preference which in turn partly stems from the visibility of the constituent stocks of an SMA portfolio: investors have a preference for the stocks they know and understand (generally larger market capitalisation stocks) as well as low turnover.
This view is based on the perception that the investment manager has a greater degree of conviction in their stock picks.
The limited universe of Australian equity SMAs is reflected in the number reviewed by S&P in its last sector review – less than 20.
Nevertheless, the general quality of investment managers in the space is high. Ratings were either three or four stars.
Managers can be split into two groups: those that only manage SMAs, and those that offer managed funds and have established SMAs that mirror an existing unit trust.
For example, Perennial Investment Partners provides a SMA version of its Perennial Growth Shares unit trust.
For the investor, the decision to invest in a SMA should essentially be based on the same considerations as a unit trust – manager quality, investment mandate, investment view, and a range of other factors.
Where there is both a unit trust and SMA version of the same mandate, it makes sense for an investor to consider how important the relative benefits of the SMA structure are to them.
S&P Fund Services has advised that their business activity will cease as at 1 October, but meanwhile it is ‘business as usual’ and PortfolioConstruction Forum is satisfied with the integrity of the analyst opinion provided.
The major benefit of using the SMA structure with an Australian equities portfolio is the ability to access the services of a professional investment manager while retaining beneficial ownership of the underlying securities.
This allows the investor considerably more flexibility in managing the tax effectiveness of the overall portfolio, as well as a greater ability to customise a portfolio to better suit their personal preferences and goals.
The advantage of purpose-built SMA platforms is that there is much more transparency and potential for customisation than a traditional wrap or master trust. Investors are able to view entire portfolio holdings and fine-tune their portfolio holdings.
However, investors also need to consider whether their investment strategy is suited to an SMA.
- In general, SMA structures are more suited to low-turnover investment strategies. A higher level of turnover increases the probability of realising short-term capital gains, which is less tax efficient. Also, high turnover will increase costs, obviously detracting from returns and potentially leading to underperformance relative to the model portfolio or underlying unit trust.
- Similarly, a SMA is better suited to a concentrated stock portfolio. A smaller number of stocks reduces the potential for stock-specific trades, which also increases transaction costs. A higher concentration of smaller stocks in an SMA portfolio could also increase transaction costs, because of a lack of liquidity at the smaller end of the market.
- SMAs are offered by large investment managers and boutiques, but van Eyk does not favour one sector over the other. Each has its strengths and weakness. Boutiques can have a better understanding of the implementation issues around SMAs, whereas large groups are often better resourced and have more robust systems.
- Given that an SMA will generally be based on a model portfolio of stocks, the abilities of the managers of that portfolio will be critical. In its most recent review of SMA providers, van Eyk gave high ratings to those with a highly skilled, experienced, well-resourced, nimble investment team. While no provider achieved the top AA rating, six received an A rating, based to a significant extent on the quality of the underlying investment team.
While the ability to easily deviate from a professionally-managed model portfolio when investment opportunities arise is rightly seen as a strength of SMAs, it can also be a weakness if the investor introduces inefficiencies as described above, or simply makes bad investment decisions.
There are a number of advantages for investors in having a direct equities portfolio managed in an SMA structure:
- Professional investment management: An Australian-equity SMA managed by a reputable, experienced investment manager is a much better investment solution than a direct stock portfolio managed by a broker, adviser or investor.
- Direct ownership: The underlying portfolio of stocks is held directly in the client’s name, meaning the portfolio is portable. If the investor is dissatisfied with the portfolio manager, they can sack the manager and transfer the portfolio of stocks to another manager or manage it themselves.
- Tax: Unlike investing in a managed fund, any taxation consequences resulting from a portfolio transaction are quarantined to the individual investor. In a managed fund, there may be imbedded capital gains within the unit price that an investor buys into when investing in a fund. In addition, the manager may be forced to sell stocks to meet other investors’ redemption requests, again resulting in taxation consequences for the remaining investors.
- Portfolio transparency: In general, portfolio managers of SMAs disclose the full stock names and weightings of the portfolio to investors (sometimes on a delayed basis), so investors have better knowledge of the stocks they own.
- Portfolio characteristics: SMA portfolios tend to be a lot more concentrated in terms of the number of stocks held than managed funds, and as such are more in line with how an individual investor would themselves invest.
However, there are a number of potential drawbacks to be conscious of when considering a SMA structure. These include the following.
Lower quality managers
The availability and accessibility of a number of SMA portfolio administrators has opened the market to new and/or small, less reputable portfolios managers to manage direct equities portfolios for investors as a way to generate investment management fees based on funds under management.
The barriers to entry (especially from a cost perspective) are much lower for a SMA manager than for a managed fund manager.
As a result, it is important to select a SMA manager that has a strong track record, a well-resourced and experienced investment team, and a defined and robust investment process. The universe of fund managers managing SMA portfolios is significantly smaller than the universe managing managed funds.
Inexperienced SMA managers
As an extension of the above point, it is important to select a manager who is experienced in the management of SMA portfolios, because it requires a different approach compared to managing a managed fund.
We have seen successful, reputable fund managers manage SMA portfolios in the same way as their managed fund – and this is usually disastrous, as high levels of portfolio turnover can generate high transaction costs and tax implications for investors.
Transaction costs can be high in some SMA offers where flat (e.g. $25) contract note charges for each transaction can become expensive for investors with smaller portfolios. This can be the case even for relatively low turnover managers.