Source: Morningstar Direct, as of 01/31/2024
What about high-net-worth investors?
While easy to implement, allocating to a single balanced fund isn’t ideal for high-net-worth investors for a number of reasons. First, these funds don’t offer any customization or flexibility – the portfolio manager determines the allocation, geographic diversification, market cap, credit quality, and duration. Second, the fees are inflexible to investment levels. All shareholders pay the same management fee, which averages 103 basis points for the category. Finally, these funds are insensitive to taxable investors with just 1% allocating to tax-exempt municipal bonds.
Fortunately, through a separately managed account (SMA), investors can own a simple 60/40 stock/bond portfolio with tax-efficiency, lower fees, and flexible customizations. The rub is that the minimums are higher – generally in the $250,000 range for this type of account.
Tax-sensitive investing
The stock portion of the account employs a Direct Indexing strategy which attempts to match an index’s performance pre-tax and outperform it on an after-tax basis. By owning a subset of the index’s holdings, the manager can systematically tax loss harvest stocks that have declined in value, replace them with another stock, and avoid a wash sale. The banked losses can be used to offset capital gains realized in other parts of the portfolio or to offset $3,000 in ordinary income annually. Indexing also keeps a lid on the account’s management fees.
The bond sleeve is actively managed, because indexing isn’t practical due to the sheer number of bonds in the index. Investors benefit from the manager’s expertise in selecting credit, duration, and sectors, and get better pricing on bulk purchases.
The tax efficiency of the account is optimized when Direct Indexing is paired with municipal bonds. The 60% in stocks can generate tax losses while the 40% in municipal bonds can provide tax-exempt income. Depending on the client’s domicile, they might be able to request all the bonds be issued by their home state. In that case, the interest income is exempt from both federal and state taxes. Clients in lower tax brackets may be better off with taxable bonds, so they can opt for a mix of high-quality government and investment grade corporate bonds.
Customization and tax-efficiency
While the 60/40 allocation is often the default option for investors, an SMA offers the flexibility to select a different allocation. The S&P 500® large cap is the most popular index option, but more diversified all-cap and global indices are also available.
The managed account structure allows for customization since it holds individual stocks and individual bonds, each with their own cost basis and tax lots. That means the portfolio manager can accept securities in-kind, which is often low-basis stock the investor owns. Taking securities in-kind can reduce the tax burden on transitioning assets. This is especially attractive to clients who are changing advisors, custodians, or outsourcing management for the first time.
Beyond customization, the investor can personalize their one-account balanced portfolio by aligning it with their personal values. That might mean excluding a particular stock where they already have adequate exposure. Or it could mean excluding companies involved in a particular business, like the manufacture or sale of alcohol.
Finding the right portfolio
At the end of the day, the right portfolio for an investor is the one they can stick with through the market’s ups and downs. The 60/40 is a time-tested allocation that usually fits that bill. Because it can be implemented in a variety of ways, investors need to think about how simple or complex they want to get.
Harkening back to Perlis’ quote, simplicity is achieved after first tinkering, exploring, and then realizing that complexity isn’t necessary. There’s something elegant and compelling about the simple 60/40 that’s mostly indexed, tax-managed, low fee, and available with a few, but not too many, customization options (Figure 3).
Figure 3: SMAs offer more opportunities for funding, customization and tax management
