Why passive investing may not be enough—and how to do more

Exchange-traded funds (ETFs) are appealing if you’re an investor with a lot of cash who’s looking for tax-efficiency¹ and passive equity index exposure—as so many are these days.

But as compelling as ETFs are, you might be surprised to learn that a tax-managed separately managed account (SMA) might be your better choice.

ETFs pool investors’ money in a fund that invests in stocks, bonds or other assets. In contrast, with an SMA, you are the only account holder and have direct ownership of each stock—which gives you the important flexibility to harvest tax losses and gift tax-efficiently to charities using the underlying holdings, as well customize your exposure.

It is important to evaluate your situation, needs and preferences when determining whether to invest into a tax-managed SMA or an ETF. There are reasons to choose an ETF over an SMA: e.g. if you are uncomfortable with the tracking error² inherent in tax-loss harvesting strategies, prefer a single line-item position, or are looking for a lower management fee. But the appeal of SMAs is also great and may be worth your consideration –  we think that it’s important for investors to consider a tax-managed SMA³ for the passive equity allocation in their portfolios.

Benefits of a tax-managed SMA: potential tax savings, flexibility to tailor the portfolio to the investor’s preferences, tax-aware transitions, and tax-efficient gifting

The direct access an SMA provides to underlying names allows the investor to tax-loss harvest for potential tax savings, customize their portfolio to reflect their values or manage concentrated exposures, to transition holdings tax-efficiently, and to engage in tax-advantaged charitable gifting.

• Tax-loss harvesting― The SMA’s design allows investors to achieve diversified index exposure similar to that provided by an ETF. However, the SMA enables you to sell individual stocks at a loss to offset capital gains elsewhere in your portfolio. Even in upwards-trending markets, some names in the index are likely to lose value over the year – creating opportunities for loss harvesting and enabling you to take advantage of market volatility, as long as you avoid the “wash sale” rule⁴. To achieve this with an ETF, you’d have to wait for the whole index to go down and sell the ETF shares.
  Of course, offsetting realized gains can lead to significant potential tax savings on your tax bill⁵. And if you kept today’s tax savings invested, your savings can compound over time.
• Values-aligned investing― The underlying exposure of an ESG ETF is determined by the index that the ETF is attempting to replicate, leaving the investor no ability to adjust exposures.
  In contrast, an SMA offers the ability to screen investments based on the investor’s preferences. You could, for example, exclude exposure to companies involved in tobacco production and avoid companies in which you already have a concentrated exposure.
• Concentrated exposures― For investors with concentrated holdings, getting broad ETF exposure may be suboptimal from a diversification standpoint – given the ETF will have exposure to the same companies or industries as the concentrated positions.
  
  With an SMA, investors can get a diversified portfolio beyond their concentrated position as there is flexibility to exclude individual stocks or industries that the investor may already have exposure to. In addition, tax losses generated by tax-loss harvesting in an SMA can be used to offset gains resulting from the sale of concentrated positions.
• Tax-aware transitions―As an ETF investor if you want an alternate exposure, making the change can be quite tax-inefficient. You’d have to sell out of your ETF investment to fund your desired exposure; however, if your ETF investment appreciated, liquidating would come with a tax cost.
  
  In contrast, SMAs can offer the ability to transition while minimizing the tax impact of appreciated holdings, given they’re able to hold onto overlapping positions between the old and new accounts to avoid unnecessary tax and transaction costs, and can achieve the desired exposure over time while being sensitive to the investor’s tax budget.
• Charitable giving—Because ETFs don’t provide access to underlying holdings, they can’t be gifted as flexibly as SMAs.
  
  You can gift the entire shares of the ETF, of course. However, an SMA allows you to select individual stocks that appreciated highly, thus relieving you of the need to pay taxes on significant gains. For, in addition to the deduction for the fair market value of the gifted security, any embedded gain (and subsequent tax liability) vanishes, as charities do not have to pay tax when a position is sold.
  
  For investors who itemize deductions on their tax returns instead of taking the standard deduction, donating qualified appreciated stock that’s been held for over a year to a public charity (including a donor-advised fund) or private foundation generally allows the investor to take a tax deduction for the full fair market value (subject to limitations based on adjusted gross income)  that can be used in the tax year in which the gift is made with any excess charitable deductions generally carried forward for use in five subsequent years. The donated stock can then be bought back right away at the higher basis, without violating the Wash Sale Rule. Furthermore, the capital gains tax that would be incurred from selling the stock and donating the proceeds can be eliminated—increasing the value of the charitable contribution by over 20%.

We can help

Investors have many uses for their assets.  From charitable intents, to funding a lifestyle, to gifting to family and beyond – these goals require a holistic, tax-efficient perspective in the ways money is managed. While J.P. Morgan does not provide legal or tax advice, your J.P. Morgan team can help you and your tax advisors assess which types of investments might best serve you and your goals. Reach out to your J.P. Morgan team to learn more.

¹ETFs are structured in a way that minimizes taxes for the holder of the ETF, given their unique creation and redemption mechanism. This, combined with the low turnover of index-tracking ETFs, makes them a popular investment for the tax-savvy investor. That said, losses generated within the ETF cannot be used to offset gains elsewhere in the investor’s portfolio, because any tax losses are confined to the ETF itself – i.e., losses can be used to offset gains only within the ETF.

²Tracking error represents how closely the strategy’s returns follow those of its benchmark, by measuring the standard deviation of excess returns relative to the benchmark. Typical tracking error threshold for a tax-managed strategy that aims to track the S&P 500 index is 1%. Source JP Morgan Asset Management.

³Tax-loss harvesting may not be appropriate for everyone. If you do not expect to realize net capital gains this year, have net capital loss carryforwards, are concerned about deviation from your model investment portfolio, and / or are subject to low income tax rates or invest through a tax-deferred account, tax-loss harvesting may not be optimal for your account. You should discuss these matters with your investment and tax advisors.

⁴The Wash Sale Rule states, in essence, that a loss will be disallowed if taxpayer sells a security at a loss and acquires the same or a substantially identical security (or an option on such security) within 30 days of either side of the date the loss was realized. The disallowed loss is added to the cost basis of the substantially identical acquired security and generally recognized when the position is later sold.

⁵Note that the tax benefit is temporary. Assuming you reinvested the proceeds from a harvested loss into a similar substitute holding (without violating the wash sale rule) and its value rises, tax savings generated by harvesting losses now means that you have a lower cost basis. That, in turn, means that you may potentially have to pay more taxes in the future if you sell that substitute holding. Nevertheless, the tax deferral means that more of your money can continue to be invested and generate returns, instead of redeemed to pay tax in the year that the loss was used to offset a capital gain elsewhere in your portfolio. The value of this tax deferral depends on the amount of time that it stays invested and its growth rate.