The Future of Investing: Why SMAs Are Taking Over Mutual Funds & ETFs

by Richard Bavetz, FRC℠ | October 1, 2024

Investors today are inundated with a myriad of options when it comes to portfolio management. Among the most popular are mutual funds and ETFs, which have traditionally provided convenient access to diversified portfolios of equities and bonds. However, as investment strategies evolved, many investors began to recognize the inherent limitations of these pooled vehicles. Enter Separately Managed Accounts (SMAs)—a modern solution to replace mutual funds and ETFs that provides the diversification, flexibility, control, and performance enhancement investors seek. As Cerulli Associates has pointed out, SMAs are increasingly emerging as the future of the investment universe, offering a compelling alternative to the burdens associated with mutual funds and ETFs. SMA platforms have surged to over $12.3 trillion at the end of the first quarter of 2024, with year-over-year increases projected to be $2.4 trillion annually.

A Little History

Mutual funds and ETFs were not designed initially as long-term holding vehicles but to add value to a core portfolio of securities by broadening exposure to specific sectors, styles, countries, or asset classes. The initial idea was to provide investors with a simple way to achieve diversification beyond their core equity or bond holdings.

Investors would use mutual funds and ETFs to enhance diversification by gaining access to a wider range of securities in a particular segment of the market. For example, an investor with a core portfolio of large-cap equities could use sector mutual funds or

ETFs to gain exposure to areas like technology, healthcare, or emerging markets, thereby expanding their risk exposure beyond their main holdings. When a particular sector or style falls out of favor, the investor would “rotate” to the sector or style that is on the rise.

Mutual funds were also created to offer access to professional management, appealing to investors who did not have the expertise or time to manage individual stocks or bonds on their own. They became popular for helping these investors add breadth to their portfolios in a readily available manner.

Over time, however, mutual funds and ETFs became the standard all-in-one solution for many retail investors, leading to their use as long-term core holdings rather than purely complementary strategies. As the financial advisory industry grew in the 1990s, more affluent investors began seeking personalized strategies akin to what institutional investors (e.g., pension funds) received. SMAs were designed to fit that bill by meeting the needs of high-net-worth individuals and institutional investors who wanted more customization and control over their investment portfolios than mutual funds or other pooled vehicles could offer. Over time, SMAs have become accessible to investors with assets worth $350-$500,000.

Despite this evolution, the original intent of mutual funds and ETFs was lost on retail investors and 401k plan sponsors. SMAs came along and filled the space so mutual funds and ETFs could be used sparingly as originally intended to supplement a core portfolio and enhance diversification rather than serve as a sole, long-term investment solution. Let’s take a look at the “Why.”

The Challenges of Mutual Funds & ETFs: Over-Diversification & Dampened Returns

Mutual funds and ETFs have long been celebrated for their ability to provide diversification—a concept that reduces risk by spreading investments across various securities. This principle is central to portfolio management and is particularly beneficial for investors who want to avoid the concentration risk of owning too few securities. However, too much diversification can become counterproductive. With mutual funds and ETFs, the sheer number of holdings often results in what can be described as "blanket diversification," which ultimately waters down the portfolio's growth potential.

In a typical ETF or mutual fund, there are typically hundreds or, more often, thousands of individual securities, each representing a tiny slice of the portfolio. This large number of holdings is designed to minimize risk but comes at the cost of performance potential. This is because mutual funds and ETFs hold a mix of “the good, the bad, and the ugly"—securities that perform well, securities that are mediocre, and securities that are outright underperformers. Unfortunately, the poor performance of the weakest holdings tends to drag down the returns of the overall portfolio, making it difficult for the fund to outperform or add meaningful value.

This problem is particularly pronounced in index-tracking funds, which aim to replicate the performance of a particular benchmark. The manager must include every security in the index in these funds, regardless of its quality or growth potential. This means that investors inevitably own the laggards alongside the winners. As a result, the potential for capital appreciation is limited, and the dampening effect of underperforming securities can lead to disappointing returns over time.

Transaction Costs and Forced Trading: The Hidden Costs of Mutual Funds and ETFs

Another significant drawback of mutual funds and ETFs lies in transaction costs, which are often exacerbated by fund manager behavior and other investor activities. In a mutual fund, the fund manager must regularly rebalance the portfolio to meet the fund's objectives. This process involves buying and selling securities, which incur transaction costs such as brokerage fees and bid-ask spreads. These costs can add up over time, eroding the investors' returns. Moreover, in actively managed mutual funds, frequent trading can be a source of significant expense, ultimately reducing net returns.

Also, mutual funds must accommodate investor inflows and outflows, contributing to transactional drag. When investors redeem their shares, the fund manager may be forced to sell securities at inopportune times to raise cash, resulting in potential losses and higher transaction costs for the remaining investors. Conversely, managers may be compelled to invest new cash quickly during periods of large inflows, regardless of whether market conditions are favorable. This constant buying and selling creates an inefficiency that weighs heavily on the overall performance of the fund.

ETFs are generally more tax-efficient than mutual funds due to their unique creation and redemption process involving in-kind transactions. However, they are not immune to transactional challenges. ETFs must rebalance to maintain their target allocations, particularly in sector-based or actively managed ETFs. These rebalancing activities also come with associated costs that can reduce overall returns.

The Bond Fund Dilemma: No Maturity, No Certainty

For bond investors, mutual funds and ETFs present additional challenges. One key benefit of holding individual bonds is the certainty of principal repayment at maturity. When investors buy a bond, they know they will receive their principal back if they hold it to maturity and the issuer does not default. This provides a level of predictability and security that is particularly valuable in a fixed-income portfolio.

Bond mutual funds and ETFs, however, do not have a fixed maturity date. Instead, these funds hold a continually shifting pool of bonds, meaning there is no guarantee of principal preservation. The value of a bond mutual fund or ETF fluctuates with changes in interest rates and market conditions, and investors risk losing part of their principal if they need to sell during a downturn. This lack of predictability can be a significant drawback for investors seeking stable income and principal preservation.

Bond mutual funds and ETFs often include bonds of varying credit qualities, mixing high-grade and lower-quality bonds. While this approach aims to enhance yield, it also increases risk and exposes investors to potential losses from lower-rated issuers. This mix of bonds can dilute the reliability and stability that many fixed-income investors seek, further underscoring the limitations of bond mutual funds and ETFs.

The SMA Advantage: Customization, Control, and Meaningful Diversification

Separately Managed Accounts (SMAs) address many of the challenges inherent in mutual funds and ETFs by providing a more tailored and flexible investment approach. Unlike pooled vehicles, SMAs are individually managed accounts in which the investor directly owns the underlying securities. This offers several key advantages that make SMAs a more modernized and effective investment solution.

Meaningful Diversification Without the Drag

With an SMA, investors benefit from meaningful diversification without the drawbacks of over-diversification. The portfolio manager can select a focused number of high-quality securities that align with the investor's specific objectives and risk tolerance, avoiding “the good, bad, and ugly" mix typical of mutual funds and ETFs. This approach ensures that each holding has been carefully chosen to add value to the portfolio, enhancing the potential for superior returns. By avoiding underperforming or low-quality securities, SMAs provide a more efficient means of achieving growth while managing risk.

Control Over Transaction Timing and Costs

SMAs offer greater control over transaction timing and costs, as the portfolio manager can make investment decisions based on the investor's unique needs and market conditions. Unlike mutual funds, where managers must buy or sell securities to accommodate the actions of other investors, an SMA manager only makes trades that are in the best interest of the individual account holder. This eliminates forced trading, which often results in higher transaction costs, and reduces the inefficiencies associated with investor inflows and outflows.

The first principle of investing is to Hold onto More of Your Money. By eliminating Revenue Sharing, Brokerage Commissions, Cash Drag, and other hidden forms of erosion, SMAs keep the money where it belongs: In the investor's account.

SMA investors can benefit from tax-efficient management by having direct ownership of the securities. Although tax efficiency may not be the primary concern for all investors, the ability to implement strategies like tax-loss harvesting and control the timing of capital gains can add significant value over time, especially for high-net-worth individuals and business owners.

Bond Certainty: Control Over Maturity and Quality

For fixed-income investors, SMAs provide the ability to build a bond portfolio with fixed maturities, offering the predictability and principal preservation that bond mutual funds and ETFs lack. An SMA manager can construct a bond ladder that aligns with the investor's future cash flow needs, ensuring bonds mature at specific intervals to provide liquidity when needed. This level of customization is invaluable for investors who rely on their fixed-income investments to fund specific financial goals.

In addition, the portfolio manager can focus on high-quality bonds that match the investor's risk tolerance, avoiding lower-rated issuers that could introduce unnecessary risk. This selective approach allows investors to achieve the stability and reliability they seek in a fixed-income portfolio without the uncertainty of a pooled bond fund.

Transparency and Customization

Another significant advantage of SMAs is transparency. In an SMA, investors can see exactly which securities they own and understand the rationale behind each holding. This level of transparency provides peace of mind and allows for a deeper understanding of the portfolio's risk profile and performance drivers. In contrast, mutual fund and ETF investors may not have as much visibility into the specific holdings or the reasons behind the manager's investment decisions.

Moreover, SMAs offer a high degree of customization. Investors can work with the portfolio manager to design a strategy that aligns with their unique objectives, excluding specific sectors or companies, focusing on socially responsible investments, or managing specific liquidity needs. This personalized approach ensures that the portfolio is built to meet the investor's specific requirements rather than adhering to a one-size-fits-all mandate.

SMAs: The Future of the Investment Universe

Cerulli Associates has highlighted the growing role of SMAs in the investment landscape, suggesting that they represent the future of the investment universe. As investors become more sophisticated and demand greater control, customization, and transparency, SMAs are well-positioned to meet these needs. The limitations of mutual funds and ETFs—including over-diversification, the dampening effect of underperforming securities, heavy transaction costs, and the lack of fixed maturity in bond funds—have prompted many investors to seek more effective solutions. SMAs provide a modern, flexible, and efficient alternative that addresses these challenges head-on.

In a world where investors are increasingly focused on achieving their specific financial goals, SMAs offer the tools to optimize portfolio performance, manage risk through proper diversification, and ensure that each investment contributes meaningfully to long-term success. Whether for equity or fixed-income investors, SMAs represent a powerful evolution in portfolio management—one that prioritizes the investor's unique needs and delivers a level of control and customization unmatched by traditional pooled vehicles.

As more investors become aware of the benefits of SMAs, their adoption is likely to continue growing, reshaping the investment landscape and providing a better path forward for those seeking to navigate the complexities of the modern financial world. By addressing the shortcomings of mutual funds and ETFs, SMAs are proving themselves to be the next generation of investment solutions—a future that Cerulli has aptly predicted.

Visit Forbes to see Rick's Forbes Magazine Contribution on the advantages of SMAs

Richard Bavetz, FRC℠ is a Federal Retirement Consultant℠ and Investment Advisor with over 25 years of experience. As a Fiduciary, he works with High-Net-Worth investors, Foundations and Endowments, offering dynamic & innovative investment portfolios in a relationship-centered advisory role.