The Advantages of Unified Managed Accounts over ETFs
Written by Shari Hensrud
Unified Managed Accounts (UMAs) have been around for a number of years now. The original growth of UMA was born from an aging Separately Managed Account (SMA) industry and the cracks that were forming. The benefits of UMA included customization, less paperwork, efficient rebalancing, lower minimums, lower costs and tax-efficiency. Much has also been written about the benefits of UMA over mutual funds, strictly on the bases of cost and tax-efficiency. What has not garnered as much attention is a comparison between UMA and ETFs. A case is easily made for the use of UMA over ETFs, especially in the case of tax-efficiency. It might not seem obvious that UMA could be more tax-efficient, as let’s face it, ETF turnover is not that high and capital gain distributions are few and far between. However, it is on the basis of tax-efficiency that UMA really wins over ETFs. Consider the components of investment management: investment management = security selection plus portfolio management. Security selection can be provided by third parties through actively managed strategies. Portfolio management is the process of combining the managers together to remove the systematic factor bets to align the portfolio with the asset allocation target. For many strategists today, investment management = portfolio management, as through the use of ETFs there is no security selection. The right combination of security selection can result in a portfolio that has very low tracking error to the target asset allocation (not as low obviously as ETFs would) but easily created within approximately 1% expected tracking to the target allocation. Why is this aspect important? Even a modest amount of tracking error is opportunity for alpha, whereas the only source of alpha from an ETF structure is in the portfolio management. For a UMA structure you get the same benefit of the alpha from portfolio management but also a little extra opportunity for alpha from the security selection, but not so much as to significantly negatively impact alpha.
Now add to this the element of Wealth Management. Wealth Management = Investment Management + customization. In this step, you conduct investment management around the real situation of a client. It is important to deliver tax management with marginal incremental risk. A key component of customization is tax management. One study estimated that alpha from tax management can be from 0.3%–.6% per year. This study was based on a UMA construct with active manager within the investment management and wealth management formulas. So even in periods where you might be on the wrong side of the tracking error, tax management can reverse some, or all, of this lag. A similar study of a portfolio of ETFs, demonstrated a total of 0.77% of tax management value over a 13-year time period, less than 0.06% per year. One possible explanation for this finding is the opportunity set is very different. When you have a portfolio of 8 securities versus a portfolio of 300-500 securities the number of tax lots increases significantly as does the number of opportunities for tax management. Even in a bull market there will always be securities where the position is at a loss in the portfolio. However, when using ETFs, if it is a bull market then the entire ETF is at a gain. In a bear market you will have varying levels of loss whereas only one level of loss for the ETF.
Obviously, there are account sizes where the only choice is between that of an ETF or mutual fund portfolio. However, for larger accounts which are associated with higher net worth clients, the impact of taxes becomes a key component in their wealth management story.
 Stein, David M. and Greg McIntire, “Overlay Portfolio Management in a Multi-Manager Account,” Journal of Wealth Management, Spring 2003  https://www.betterment.com/resources/research/tax-loss-harvesting-white-paper/
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This blog post was written by Shari Hensrud, CFA, PhD, President, FDx Advisors & Chief Investment Officer