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SMAs historically had to stop there. Your only tax savings was the ability to own your own gain and maybe have one or two managers that were willing to harvest losses or offer a more tax-efficient portfolio. Cerulli Associates has done a study that showed only 30 percent of all taxable accounts got any special treatment at all.
Part of the reason this happens is because it's hard for the individual adviser to coordinate among the different investments. If you think of a client that has five SMA accounts, there are five independent managers doing their own thing. However, the client pays one tax bill. In many situations, even if the managers are trying to effectively manage taxes, it's not going to result in the best solution for the client. It's very difficult with five separate accounts for the adviser to manage those in a coordinated fashion. But an overlay manager can coordinate the managers' trading activity, and can act as the "tax quarterback" in a much more efficient way.
For example, let's say the client has a security that has been held 10 ½ months and it's had a big gain. As the overlay manager, I can hold that another month and a half and get it to long-term status.
For the typical average separate account client, about a third of his or her gains are going to be short term. That creates about two-thirds of the tax burden. By avoiding short-term gains, the overlay manager can cut taxes. Clients that have average to above-average turnover and are in a high income-tax bracket can reduce the tax burden by at least 20 basis points and sometimes by as much as 120 basis points by avoiding short-term gains.
Of course, you can avoid taxes and save the client a tax bill by never trading the account. But the whole point of hiring managers is to pick and trade stocks. The challenge is keeping consistent with their managers' stock picks while managing for tax efficiency. When we're running the account and a manager wants to trade, the first thing we're going to try to do is find offsetting losses. So we're going to harvest the loss to offset the gain that the manager is recognizing.
When there aren't losses available, we evaluate if it's okay to wait until that gain reaches long-term status. A lot of these short-term gains haven't been held a month or two; they've been held 10 and 11 months, so we're saying, let's hold off trading that security for 30 days, 40, or 50 days, and once it reaches long-term status, let's catch up with what the manager is doing.
The overlay manager can do that because we're making those trade decisions.
Overlay managers also help advisers prevent wash sales. We've found that depending on the combination of managers – large cap growth and large cap value, or small cap and large cap – wash sales can happen fairly often. For example, about 30 percent of the names in the Russell 1000 growth benchmark are also in the Russell 1000 value benchmark. That introduces the opportunity for a wash sale: sometimes when one manager is selling at a loss, another is buying it.
The other time where we see a lot of opportunities to prevent wash sales is at index reconstitution time. Say Russell or S&P decides to move a security out of one benchmark and into another. For a manager that only holds securities in the Russell 1000 growth benchmark, when it exits that portfolio, they're going to sell that position. When it enters some other benchmark, there's an opportunity for one of the other managers to pick up that position. If the first sale was at a loss, that introduces the opportunity for a wash sale to occur. What we do is make sure that doesn't happen. We coordinate the activity, and avoid buying that security until after the wash sale period has expired.
Ron Pruitt, chief investment officer, Placemark Investments. Placemark is an overlay portfolio manager that administers unified managed account (UMA) programs, a new type of managed account offering that integrates multiple investments into a single portfolio.
