Values-based investing has a long history in the United States, but recently there has been increasing interest in incorporating environmental, social and governance issues into the construction and management of portfolios.
Some investors can obtain their desired exposure with an ETF or mutual fund incorporating ESG considerations. However, these one-size-fits-all solutions have certain limitations.
In particular, many investors may find that they are better able to express their personal values in a separately managed account. And, as an added benefit, an SMA can offer the potential for tax management within the parameters of a unique mandate.
There is considerable diversity in terms of the types of ESG issues that clients and prospects are incorporating and their preferred method for doing so, as well as their ideal equity exposure. Accordingly, there can be as many unique customizations and measurements for success as there are investors.
In order to make this more tractable, socially conscious ETFs or mutual funds are normally limited to a relatively small number of choices that appeal to the broadest audience possible.
As a result, most investors in commingled funds find themselves with a level of ESG incorporation or security characteristics that aren’t particularly well-matched to their preferences. That is, funds may avoid certain companies that the investor finds attractive or include those to which the investor objects.
In an SMA, the equity exposure and ESG incorporation can operate independently, allowing investors to create an exposure with a more precise set of characteristics, such as geographic, market capitalization or style, and to select only as many screens as are truly necessary, given their priorities.
EXPRESSING SOCIAL VALUES
Beyond portfolio construction, shareholder engagement can be a powerful tool for expressing investment values, particularly for investors who are reluctant to divest completely, or to move away from broadly diversified, passive equity exposure.
Investors who are best able to employ a responsible, investing-oriented shareholder engagement strategy actually are those who want to remain fully invested in the broad universe. After all, only people who remain invested in a security have the opportunity to vote proxies or file resolutions.
In a collective vehicle, proxies are voted by the fund sponsor and there is no opportunity to file shareholder resolutions. However, in an SMA, the investor owns the securities directly and can choose how proxies should be voted or even choose to use their status as shareholder to file resolutions, subject to certain holding requirements.
One additional benefit of employing an SMA structure is the ability to employ tax management. In the case of a collective vehicle, capital losses within the fund aren’t passed through to the end investors individually.
On the other hand, realized capital losses in an SMA are passed on directly to the end investor and can be used to offset realized capital gains inside the account or elsewhere in the investor’s larger portfolio.
Under the tax laws, harvested losses that aren’t used in the current tax year can be carried over to future years. Responsible investing SMAs can be created that seek to track the pre-tax returns of the selected exposure, including any screens, while working to maximize after-tax returns.
The primary methods for this are holding securities long enough to qualify for the lower long-term tax rate, selecting loss maximizing or gain minimizing tax lots for trades and avoiding repurchases that would disallow the loss (i.e. wash sale rule).
Customizable approaches to responsible investing are needed to accommodate the diverse needs of a broad range of clients. The flexibility of an SMA framework allows both taxable and tax-exempt clients to craft a combination of exposures, screens and ESG tilts to reflect their values.
Although fees tend to be higher for SMAs, high-net-worth investors use them because they provide customization, transparency and tax benefits that commingled accounts such as ETFs and mutual funds can’t. This customization is particularly critical for investors who typically can’t find a collective vehicle that perfectly matches their values and lose control of the proxy voting decision.
Additionally, the after-tax performance of SMAs make them very compelling alternatives to ETFs and mutual funds for high-net-worth individuals and family offices.
This story is part of a 30-30 series on ways to build a better portfolio. It was originally published on March 29.