InvestmentNews: “SMA Demand and Tax Alpha Investing Are Booming. Here’s Why”

Dimensional’s Kacie Walsh Jason recently sat down with InvestmentNews anchor Gregg Greenberg to discuss the demand for separately managed accounts (SMAs) as well as the benefits of tax alpha investing.

Watch the full conversation here:

Below are some highlights, edited for clarity, from the segment:

There are a couple of things driving interest. One is expanded demand from investors themselves, who seem to have increased tax complexities as well as demand for a personalized investment experience.

Additionally, the advisor community at large is continuously driven to differentiate and compete. SMAs allow them to bring together the investment experience with the financial planning and tax experiences to provide one cohesive investment solution and service experience for their clients.

First and foremost, our goal is to maximize the after-tax return, and that’s unique in an SMA structure.

On the pre-tax return side of that equation, our goal every day at Dimensional—across all our investment solutions—is to outperform benchmarks. Many other long-only SMA managers have more of an index-tracking investment goal.

We aim to be diversified—we have up to 1,800 securities in our SMAs—and we offer systematic factor exposure, if that’s desired. We also think about flexibility in portfolio design to allow for things such as the exclusion of REITs.

On the tax management side, our objective is to go beyond just monthly tax loss harvesting, which is what you see in many other long-only SMAs. We think about daily tax loss harvesting and other levers, like income, that impact that after-tax return.

When we’ve got a concentrated stock position, we first run a tax transition analysis to look at all the underlying lots of that stock position and evaluate how much of the single security we’re willing to sell—realize some gains on, pay some taxes on—to free up cash flow to put in an SMA that’s broadly diversified around that concentrated stock position. Maybe that’s 10% of the stock, maybe it’s 50%, but we want to give flexibility in how we manage that tax transition into the SMA.

Then from there, every single day, we look for tax loss harvesting opportunities across all those securities around that concentrated stock position. If we capture a loss in one of those securities, we’ll realize a gross gain in the original stock. And over time, we’ll work to unwind that tax impact as tax neutrally as possible.

Tax alpha is describing the additional return on an investor’s after-tax return that comes from the tax management approach in an investment solution. That tax alpha is the extra on top, which is really valuable in terms of the dollars you live off of.

You want to think about tax alpha with a lens that’s inspective of what is actually going on in that calculation. It’s important to ask what’s driving the tax alpha. Is it just tax loss harvesting or is it other components of tax management—like income management, which is actually a tax savings—that improves that after-tax return in an investment portfolio?

Additionally, there are a lot of conversations in our industry related to whether it’s possible to get alpha on the pre-tax return. At Dimensional, we’ve shown that it is possible on a pre-tax return through a systematic, factor-based investment approach.