The size of the separately managed account market has continued to grow. A recent industry report by Cerulli Associates identified assets in this space as totaling $10.7 trillion at the end of 2022, up from $7.4 trillion in December 2019. Financial innovation has followed this growth as new product types have been and are being developed to provide advisors with improved ways to assist clients in meeting their financial goals.
One such opportunity that is on many advisors’ minds is the conversion of an advisor’s book of separately managed accounts into exchange traded funds. Following is a discussion of some of the key considerations when weighing such a decision and the impacts it may have on your clients and your firm.
1. Tax Efficiency
Taxes are a critical component when calculating the true return of any specific investment. Most often, a client will focus on the day-to-day expenses that flow through an account but they fail to regularly consider the larger bite that could come at tax time. By design, an ETF is a more tax efficient investment product than a mutual fund or an SMA. This is because the creation and redemption process takes place via what are termed “in-kind transactions.” These in-kind transactions are not considered taxable events, giving the ETF structure a notable advantage over other vehicles when it comes to managing tax implications.
However, while the long-term tax picture may seem positive, an advisor contemplating such a conversion must consider the taxable implications of the conversion itself. In some instances, a conversion may qualify as a non-taxable event under Section 351 of the U.S. tax code, which deals with specific types of asset transfers. In other scenarios, advisors have been able to utilize market drops to convert accounts in a tax efficient manner. Either way, careful consideration and careful planning is needed to help ensure that, in an effort to help clients mitigate their tax exposure, an advisor inadvertently saddles them with a significant tax liability.
2. Benefit of Scale
Scale can yield many additional opportunities for an investment portfolio. By converting an SMA platform to an ETF, an advisor can offer their clients increased efficiencies in more ways than just taxes. One primary benefit of scale is that an ETF can more easily access complex instruments that are difficult or even impossible to obtain on an SMA platform. This can manifest in a number of different ways. For example, certain derivatives, true foreign securities, private placements, and hedge funds may not easily fit in an SMA setting. However, such investments are quite routine in the ETF space. Not only does this open up potential new investment types to an advisor’s clients but, as a result of the size advantages from the single ETF, it can also be easier for an advisor to properly maintain a desired target allocation.
The ETF model may also help simplify an advisor’s operations. In an SMA platform, an advisor must manage tens if not hundreds of thousands of separate client accounts in an efficient manner. This oversight can require significant investment in additional hardware, software, and/or staff to perform such nuanced oversight. However, if an advisor were to transition to a handful of strategies that are offered via an ETF, they may have more streamlined client reporting, trading systems, portfolio management, and compliance oversight, delivering increased efficiencies.
3. Fee Considerations
As the advisor realizes certain economies of scale, it is quite possible to realize potentially significant savings on behalf of clients. For example, in the ETF wrapper the advisor’s management fee is deducted directly from fund assets and, as a result, is accounted for when calculating an individual investor’s gain or loss. This is in contrast to an SMA account where the fee is collected outside of the specific investments and cannot be claimed as a deduction.
For the advisor, the cost to launch an ETF has come down considerably while the options for launching such a fund (via a white label, taking a DIY approach, etc.) have increased. The fee compression that has benefited clients can also be realized for an advisor that is looking to make a nominal investment that could yield benefits for decades to come for both clients and the advisor.
4. Larger Universe of Possible Investors
Porting a strategy into an ETF wrapper opens up the possibility for additional investors to identify and recognize an advisor’s investment offering(s). Serving as an advisor to an ETF, which is traded on a national exchange, carries a level of institutional sophistication that can increase brand awareness. For clients, the ease of access via intraday trading is also a valuable proposition.
It is important to note though that with the increased opportunity for attention comes the potential for increased scrutiny. SMA performance is not available on all major brokerage platforms, updated by the minute. ETF performance is. For some advisors, that kind of openness is an exciting new proposition. For others, it can come as a bit of a shock.
Leverage the ETF Ecosystem
It is important that an advisor discuss with legal and tax counsel well versed in SMA to ETF conversions at the onset in order to navigate a successful conversion. Financial innovation and recent regulatory changes have made it easier than ever to make a wealth manager into an ETF manager, and the financial services industry possesses a critical mass of highly experienced service providers that are able to walk alongside an advisor that is looking to build such a structure. For all of these reasons, it is easy to understand why an advisor should thoughtfully consider the benefit to clients from converting SMAs to an ETF. While a conversion would require some upfront investment, there is a significant opportunity for an advisor to build a platform that is more efficient for not only the client but equally so for the advisor.
Aisha Hunt, Principal, Kelley Hunt & Charles, PLLC
Aisha Hunt is a Principal at the law firm Kelley Hunt & Charles (“KH&C”), which specializes in institutional asset management legal services, and was formerly a partner at Dechert, general counsel at ALPS and Vident Financial. Aisha (Kelley) Hunt brings more than two decades of legal and financial services industry experience to her role as founder of Kelley Hunt & Charles, PLLC, a women and minority owned law firm. Kelley Hunt & Charles specializes in helping asset managers with all legal aspects of launching, converting and managing ETFs, mutual funds, interval funds and other investment products across a wide variety of asset classes, including ESG and digital assets. Prior to her most recent role as General Counsel at Vident Financial, Ms. Hunt was General Counsel at ALPS and a Partner at Dechert LLP. She has also held senior in-house legal counsel roles with Wells Fargo and Dodge & Cox.
Ryan Charles, Principal, Kelley Hunt & Charles, PLLC
Ryan Charles is also a Principal at the law firm KH&C and was formerly the general counsel of Davis Selected Advisers, prior to serving as a senior attorney with U.S. Bank’s Global Fund Services team. For over 20 years, Ryan Charles has served leading investment advisers, fund boards, mutual funds, ETFs, UCITS, other collective investment vehicles and broker-dealers. Ryan spent the first 18 years of his legal career at Davis Selected Advisers, L.P., where he was a limited partner and General Counsel. Most recently, Ryan held senior roles as an Attorney on U.S. Bank’s Global Fund Services Regulatory Administration team.