The following vignette, part of our “SMAs at Work” series, describes how a hypothetical financial advisor could use Dimensional SMAs to meet the needs of a prospective investor. The advisor’s firm has already signed an investment management agreement with Dimensional.
In Part 1, the advisor hosts Lorenzo, a prospective client who inherited a large and highly concentrated stock portfolio from a relative several years ago.
During two previous meetings, Mary has gotten to know Lorenzo and his investment goals. Lorenzo’s portfolio has roughly $5 million across 30 US stocks, but Lorenzo is interested in a more diversified portfolio of US equities that uses a systematic approach to pursuing higher expected returns and managing risk. Lorenzo also wants to meet his philanthropic goals with ongoing charitable donations, and he is concerned about minimizing capital gains in a portfolio transition and in future account management.
Mary uses Dimensional’s SMA Center to begin building a customized solution to share with Lorenzo. First, to pursue Lorenzo’s investment goals, she decides on the SMA US All Cap Core Equity 2 strategy. She designates standard tax management for Lorenzo’s portfolio on an ongoing basis, uploads his current holdings into the SMA Center, and requests a Tax Transition Analysis. Mary is particularly interested in the tradeoff between the estimated capital gains that Lorenzo would incur in a portfolio transition and overlap, a metric that indicates how closely Lorenzo’s portfolio aligns with the SMA US All Cap Core Equity 2 strategy (as measured by the overlapping portfolio weight of stocks held in both).1
Example of Tax Transition Analysis
Example is hypothetical and for illustrative purposes only. This example illustrates the tradeoff in a portfolio transition between overlap with the customized strategy and estimated realized capital gains. The customized strategy represents a starting strategy with investor preferences applied.
The Tax Transition Analysis produces three scenarios for Mary to discuss with Lorenzo:
- Minimize Net Gains offers a moderate transition that results in almost no estimated capital gains but relatively low overlap with the SMA US All Cap Core Equity 2 starting strategy.
- Balanced falls in the middle regarding estimated capital gains and overlap.
- Maximize Overlap offers the highest overlap but also the highest estimated capital gains.
The Tax Transition Analysis provides a summary of key equity characteristics and estimated capital gains using thoughtful and robust data lenses.
When presented with Mary’s analysis, Lorenzo is pleased with the options because they allow him to make a well-informed decision for the transition. He also appreciates the ongoing tax management that will occur within his customized SMA. Unlike some solutions presented to Lorenzo by other professionals, the Dimensional SMA does more than tax loss harvesting. As it seeks to minimize realized capital gains and harvest losses, the solution also evaluates the daily tradeoffs involved in pursuing higher expected returns and diversification while seeking to minimize costs and taxes. It also considers the tax efficiency of dividend income and monitors for charitable gifting opportunities not only around year-end but also, for example, around corporate actions and portfolio rebalancing.
Because of Lorenzo’s tax sensitivity, Mary anticipates that he will want to see after-tax performance reporting in the future. She will obtain that information easily because Dimensional will report returns on an after-tax basis after she inputs Lorenzo’s tax rate.
Ultimately, Lorenzo and Mary decide the best option for him is Scenario 3: transitioning to the designated strategy and incurring the estimated capital gains. Mary signs Lorenzo as a client during their third meeting and schedules more time with him to onboard with the firm.
Looking ahead, Mary brings up the Custody Account Setup Instructions from the User Resources page on MyDimensional. Once she gains connectivity to Lorenzo’s custody account, she designates the tax lot relief methodology, proxy voting preference, and setting for communication notifications to properly launch Lorenzo’s SMA. Because Mary already has Lorenzo’s SMA proposal in the SMA Center and does not need any additional paperwork, it is easy for her to launch the SMA and track progress.
Mary and her colleague Ben have decided to set up their SMA Center workspaces such that each can view the SMA investments managed by the other—both live, funded accounts as well as those not yet finalized. This step supports their team-based approach and allows for continuity when one partner is on vacation or out sick. When Mary is finished with her meetings for the day, she consults with Ben about their accounts. Before going home, Mary sees a notification from the SMA Center indicating that an account she had launched for a client two days ago is now live and funded.