Mutual Funds vs ETFs vs SMAs: Which is the Best For You? (EP.219)

0:28We all need to make smart decisions with our money. Glasses clink and everyone seems to be ordering with reckless abandon. One friend orders a round of craft cocktails. Another insists on a seafood tower for the table, even though maybe you don't eat shellfish. Someone else quietly orders the most expensive steak on the menu. And you, being reasonable, stick with a modest entree and maybe a glass of wine. The meal ends and the server comes over with the check. Only instead of asking how you'd like to split it, they announced that the restaurant only accepts one card and the bill will be divided evenly across the table.

1:07Suddenly, you're subsidizing the cocktails you didn't drink, the shellfish you didn't touch, and that steak you never tasted. You didn't choose those things, but you're paying for them anyways. And that, my friends, is essentially how a mutual fund works. Investors pool their money together into one big pot, and a fund manager buys the securities that pot is supposed to hold. But when another investor decides to cash out, maybe to pay their own living expenses, the fund manager has to sell securities to raise that cash, and those sales realize taxable gains or losses. And at the end of the year, those tax consequences get distributed to everyone who owns shares in the fund, whether they sold anything or not.

1:55In other words, the actions of strangers at the table can directly affect your final bill. And just like a frustrating dinner check, it often leaves investors with a bad taste in their mouth. And that frustration is a big reason why ETFs and SMAs became so popular in the first place. because they're designed to give you more control over your own portion of the bill. For decades, mutual funds were the default option, just like splitting the check evenly was the default at big group dinners. But investors eventually demanded better. They wanted their own bill. They wanted more control over the menu, and that demand gave rise to ETFs and SMAs, which have exploded in popularity over the past two decades.

2:39Most of us already own mutual funds in our 401ks, And I also think most of us have seen that ETS have become the go-to option for low-cost, tax-efficient investing. It's SMAs, though, that were once reserved for institutional investors or the ultra-wealthy that are now far more accessible than ever before, just thanks to advances in technology. But how exactly do these vehicles work? And why does the choice matter? Maybe most importantly, which one is right for you? That's what we'll unpack in this episode. And by the end, you'll understand the differences, the trade-offs, and the situations where each one shines.

3:22Also, I have to note that there are a ton of additional resources this week in the show notes at thelongterminvestor.com. And if you've never visited the show notes before, this is probably the best week to be checking them out. I put a ton of work into these show notes. Honestly, I think I put more effort into my show notes than any other podcaster out there. So visit the longterminvestor.com to check out the additional resources that go along with this episode. Now, I always start by framing the comparison between mutual funds, ETFs, and SMAs with the same simple scenario. Let's imagine you and I, along with a few other investors, decide that we want to invest in a fund tracking the Russell 3000, which is a broad U.S.

4:09index that essentially captures the entire U.S. stock market. If we do this in a mutual fund, we pool our money together and the fund manager uses that money to go out and buy the stocks in the Russell 3000. Easy enough. But here's where it gets interesting. Suppose I want to sell my shares to cover living expenses. The mutual fund manager has to sell securities to raise cash for my redemption. And when they do that, they realize gains and losses inside the portfolio. Those gains and losses get distributed to all the shareholders at the end of the year. And because the stock market usually goes up over time, it's usually gains that they're distributing to shareholders at the end of the year.

4:49So my decision to sell creates a tax bill for you, even if you didn't sell anything. That's the quirk of mutual funds that makes them relatively tax inefficient. Now, compare that to an ETF that tracks the Russell 3000 on your brokerage statement. It looks almost identical. It has a ticker symbol. It has a value per share. But when I sell my ETF shares, the mechanics are completely different. It's actually a little bit complicated, and I'm going to simplify it for the purposes of this episode. Just think, instead of the fund manager selling securities like they do in the mutual fund, the ETF manager transfers a basket of securities to a middleman known as an authorized participant who then handles the redemption in exchange for cash for me.

5:35But because the ETF manager never actually sells the securities, they're transferring them in kind. My redemption of the ETF to meet liquidity needs doesn't trigger taxes that impact you or the other shareholders. And that's really one of the main reasons, if not the reason, that ETFs are more tax-efficient than mutual funds. And then there's the SMA, or the Separately Managed Account, or as some people have grown to call them, direct indexing. This is like having a mutual fund or ETF that is just for you. So instead of pooling money with others, the asset manager is running the strategy in your own account.

6:15The same Russell 3000 exposure, but the stocks sit directly in your name. That means if we want to harvest losses, we don't need the entire U.S. stock market to be down like we do with a mutual fund or an ETF. We just need a handful of individual stocks in that index that happen to be trading below where we bought them. And trust me, there are always individual stocks trading at a loss, even in a year when the market is up. And there is a chart in the show notes at the longterminvestor.com that shows exactly this. I really encourage you to check it out if you don't believe me. It's also just a cool chart to see in the first place.

6:53And that difference, the tax-loss harvesting at the individual security level, is one of the biggest reasons SMAs have become more popular. So at a high level, the framework that I have built out here is that you have these mutual funds, which are pooled assets that are relatively tax inefficient, but easy to use and widely available. You have the ETFs that are also pooled assets, but structured for tax efficiency and often a little bit cheaper. And then you have the SMAs that are not pooled, more customizable and capable of generating tax alpha. Now, I'm going to look at each one of these individually and explain when they are most useful.

7:33Mutual funds, I feel like everybody's familiar with them. They've been around since the 1920s. They really actually just became mainstream in the late 20th century, especially once the employer-sponsored retirement plans like 401ks, 403bs, 457s. That's when they really took off. And to me, the biggest advantage of using a mutual fund is that they are incredibly easy to trade. In your 401k or your IRA, it's as simple as selecting a percentage of your contributions. And in a brokerage account, you can even trade a specific dollar amount and avoid having any sort of leftover cash from a transaction.

8:10The other thing that mutual funds have going for them is that they can provide access to certain active strategies that aren't easily replicated in ETFs or SMAs, specifically some fixed income strategies or liquid hedge fund strategies. And look, I think a big reason for why this is true is that compared to an ETF, a mutual fund is a little bit less transparent, which is generally something you're not wanting. But when you're an active fixed income manager, for example, an ETF effectively forces those active managers to show their hand to the market on a daily basis, where the mutual fund, on the other hand, it allows them to better protect their secret sauce because you're only disclosing holdings on a monthly basis.

8:54Now, before all you passive nuts go crazy, I would encourage you to check out episode 99, The Problem with Bond Indexes. Again, And I'll link to it in the show notes at the longterminvestor.com. The thing is that the active versus passive debate simply is not the same with fixed income as it is with equities. So go check out that episode. And I think it is a reasonable consideration that you might, when you're trying to figure out, do I use ETFs or mutual funds? There are some active fixed income strategies where I think a mutual fund is a better wrapper than an ETF. Now, the biggest drawback of mutual funds is the one we've already discussed, and that's tax inefficiency because the way redemptions work, you're at the mercy of other shareholders.

9:37And if enough people redeem, the fund might have to sell appreciated securities, which creates those taxable gains that get distributed to everyone, even if you never sold. And that's why I think sometimes mutual funds can feel like tax surprise generators. Do they still have a role? Yeah, I think they do. They absolutely dominate retirement plans, and I don't think anything is going to change with that. And when mutual funds have an ETF share class, which is currently something only Vanguard is allowed to do, but it does sound like ETF share class exemptions is coming from the SEC for other asset managers.

10:10Well, then the tax efficiency issue isn't as prevalent. This is a little nuanced. So I do think I'm going to explain this more in a future episode, but I think it's probably beyond the scope of today's conversation. Let's go ahead and move to ETFs, or exchange-traded funds, which first came around in the 90s, but their popularity really skyrocketed after the financial crisis alongside the move to passive investing in equity investments. Today, ETS as a whole has completely overtaken mutual fund flows. On the surface, ETFs look a lot like mutual funds. It's the same idea. It's the pooled money.

10:49It's professionally managed. It's often tracking an index. But under the hood, the structure is very different. And the key distinction is the creation and redemption process. I explained this already quickly, but I'm going to do it again. I'm going to simplify it a little bit for the benefit of the episode. But when new shares are created or shares are redeemed, the ETF manager works with authorized participants who are these large institutional middlemen to exchange securities in kind, meaning that the ETF isn't constantly selling securities to raise cash, but instead they are handing off securities directly to this authorized participant.

11:29And this small difference in the plumbing creates a huge difference in outcomes. Basically, the ETFs rarely generate taxable capital gains from investor flows. Now, that doesn't mean that you can't get a capital gains distribution from an ETF, that's actually a misconception I hear from time to time. In reality, it's just far less likely that you could get a capital gains distribution from investor flows and outflows. Another thing with ETFs that I feel like people get wrong is that they'll point to the fact that they are typically free to trade these days, which is true, but is also a bit misleading.

12:05There is a blog post I wrote in 2019 that I'll link to in the show notes, again, at the long-term investor.com that goes into this in greater detail. But basically, free trading means less transparency in how the brokerages are making money off you. And I think in general, something to remember is if something is free, you are the product. You are no longer the customer. And so in this case, brokerages, they make money off the wider bid-ask spreads. Plus, they actually sell your orders to a third party for execution. And that third party then takes a small piece from the bid-ask spread. And in some really bad cases, they'll execute outside the bid-ask spread.

12:44And unless you have a Bloomberg terminal on hand, which costs about $25 ,000 a year, it is nearly impossible to do a best execution analysis. So I think of the work that we do at PlanCorp to make sure that our trades are getting fairly and accurately executed. And it's the type of thing that you just can't do on your own as an individual investor. Now, this is far from a reason to embrace ETFs. I just think it's worth clarifying because most people will point out that the cost of mutual fund commissions is a reason to embrace ETFs, which often have no commissions. And I think that's a mistake.

13:17All else equal, yes, I do think you want to own ETFs over mutual funds, especially in taxable accounts. But there is that argument to be made for the mutual fund wrapper for some fixed income strategies. But we're kind of getting into the weeds at that point. I would suggest that you would really need to know how the fixed income manager is taking advantage of that transparency thing I'm just mentioning to really be able to justify choosing a mutual fund over an ETF wrapper. Another quick, more recent benefit of ETFs that I want to touch on is the ability to participate in 351 exchanges. PlanCorp just participated in our first 351 exchange this year.

13:56And so that's definitely something I want to cover in an upcoming episode as well, but another thing that's just well outside the scope of what we're trying to cover. One last thing, it's not really worth realizing capital gains to get out of a mutual fund and into an ETF that follows effectively the same strategy. I mean, yes, the ETF is more tax efficient, but not so much so that it's worth justifying big gains. And my very unscientific guess is that it would probably take multiple decades to recover the cost of a tax bill at best. Okay, we've talked about mutual funds, we've talked about ETS, and now let's talk about SMAs.

14:33Based on the hundreds, thousands of investor portfolios I see every year of all shapes and sizes, I would say that the SMA is the most underutilized vehicle among investors with, I guess I'm going to say$5 million in assets or more, but it's perhaps the most overutilized vehicle among investors with less than, say,$2 million. So I kind of laid it out at the beginning, but a separately managed account, an SMA, or what some people call direct indexing, is like having a mutual fund or ETF that's built just for you. So instead of pooling your money with other investors, the asset manager runs the portfolio in your own account and in your own name.

15:14And those advantages are really powerful for two reasons. The first is customization. One form of customization that you see frequently with SMAs is if you want to, exclude certain stocks for environmental, social, or governance issues. But I think where I actually see them get more use, even just in my daily role at PlanCorp, is if you have concentrated stock positions or a mix of ETFs and individual stocks that don't have really an intentional strategy or don't have a strategy that aligns with what you are really trying to accomplish. And you can take those, put them into an SMA, ideally with a little cash too, And then the manager can build around them, creating a lot of intentionality, a lot of customization.

15:55That's one of the powerful advantages. The other one, and I think it's the one that most people hear about, is the tax efficiency. Because you directly own the stocks, you can harvest losses at the security level, even when the market's up overall. So if we go back to our Russell 3000 example, if you bought a mutual fund or an ETF tracking the entire U.S. stock market in March 2020, you wouldn't be able to tax loss to harvest that position unless the market falls 30 to 40 % from today's levels. And I'm not saying that doesn't happen. That type of drop happens about once a decade, but that's rare enough that you're not going to be harvesting many losses.

16:33And if you need losses, that's not going to be the most effective way about getting them. In an SMA, though, even when the index is up, many of the individual stocks within it will still be trading below your purchase price at some point in time in the year. And so those losses can be harvested to offset gains elsewhere in your portfolio or even ordinary income in some cases. And so the way this works is basically think of it as Coca-Cola is down and so you sell it and buy Pepsi or Chevron is down and you sell it and you buy Exxon Mobil, all for example. And that's the tax alpha aspect of this.

17:08It's the ability to improve after tax returns through proactive management. And look, SMAs are not perfect. They cost a bit more than ETFs. I'd say generally about 10 basis points or 0.1 % more. And they add some complexity. But in my opinion, I think when you pay more for something, if you're getting something of value, I don't really have a problem with that. I think the actual time where SMAs don't make as much sense is when you don't have a clear use for the capital losses. I just don't believe in generating capital losses for the sake of doing it. I have a blog post on that. We also have episode 162 that talks about when tax loss harvesting makes sense and when it doesn't.

17:51So I want you to check that out. It'll all be in the show notes, longterminvestor.com. And I mentioned some investors are underutilizing the SMA vehicle. Others are overutilizing it. So who should consider an SMA? The starting point for me, and this is a little bit fuzzy, but the starting point for me is higher net worth investors who are overweight liquidity. And being overweight liquidity means that you realistically don't expect to spend your money down to zero in your lifetime. And that's usually where I start to draw the line in the sand for who should and shouldn't consider an SMA. Now, when we use SMAs at PlanCorp, we want to allocate enough to them that they have a meaningful tax benefit, but not so much that it would interfere with rebalancing opportunities or potentially be needed to meet liquidity needs.

18:42Because when you have an SMA that's constantly harvesting losses and continuing to hold the winners, you end up with a low basis pot of money. So you ideally want to die with this pot of money and get the step up in basis. These days, there are some actual strategies that can work around this. You can do a long, short overlay on your SMA. You can utilize a 351 exchange to move an ossified SMA into an ETF. Again, those strategies are beyond the scope of this conversation. I'm just mentioning to highlight that there are some creative solutions that at least at PlanCorp that we're going to be using to apply to the trickier tax situations.

19:18But back to what I'm saying, you want to allocate enough to an SMA to make a meaningful tax benefit, but not so much that it interfere with rebalancing opportunities or potentially be needed to meet liquidity needs. So here's how we do this at PlanCorp. and I'm going to use a million-dollar portfolio just to keep the math simple. For starters, at PlanCorp, we have 70 % of our stock allocation in U.S. stocks and 30 % in international. And you can use SMAs to get your non-U.S. stock exposure, but I prefer to stick with the U.S. and stay as broad market as possible with an SMA exposure, really for two reasons.

19:55First of all, you want it to be a big enough opportunity set to have plentiful tax-loss harvesting opportunities. So having an SMA tasked with tracking the Russell 3000, that's plenty of companies to potentially tax lost harvest from in any given year. And remember, even in up market years, a large percentage of stocks are going to trade at losses. But if you were going to try to do it with small cap stocks or something that you have a smaller allocation to within the portfolio, it's just less opportunities for tax lost harvesting. The other thing that I like about broad market exposure as it pertains to PlanCorp and their clients is that broad market US exposure represents the largest allocation within our portfolio.

20:36Now, this is one of my longest solo episodes I think I've ever done. And if you're still tuned in, now you get some of the secret sauce that I don't think I've ever shared publicly like this. So at PlanCorp, we have three equity strategies. We have an index strategy, a factor strategy, and an ESG strategy. And I'd say that, I don't know, 90, 95 % of our clients utilize this factor equity strategy, which means they own the entire market, but they have strategic overweights to certain factors that have historically carried higher expected returns. And when I say our factor strategy still owns the whole market, roughly 60 % of our U.S.

21:12allocation is broad market exposure. And I just said our U.S. allocation is 70 % of our equities. So 60 % times 70 % is 42%. that means that 42 % of our total equity exposure is in broad US market exposure, which is a pretty nice large bucket to draw on from an SMA. So if you say, hey, 50 % of that bucket can get allocated to an SMA, just as a starting point for conversation, that gives you a lot of wiggle room to still do rebalancing and not necessarily need to tap that bucket and upset the allocation. If you have a million-dollar portfolio, what I'm describing is that the starting point would be about$150 ,000 for how big an SMA might be in a million-dollar portfolio at PlanCorp.

21:59That's just a starting point. Remember, I said people with under$2 million are over-utilizing this strategy. I don't know that you get a meaningful tax benefit from putting just$150 ,000 into an SMA. There are some instances, for example, if you're a business owner and your business is worth$10 million and you know someday that you're going to sell your business, but your liquid portfolio, at least, is only$1 million, well, then maybe that$150 ,000 SMA is worth it because any of the losses that you're going to generate are better than nothing since you know you're going to have a use case for them.

22:36In fact, I've worked with clients where we go well beyond the starting point that I've outlined. That's why it's a starting point, not a hard and fast rule. And customization will also change the conversation. I mentioned ESG considerations, but I honestly think the more common needs involve building around existing portfolio assets or having an SMA manager apply an options overlay. Going back to this rule of thumb is that you shouldn't put more into an SMA than you'd reasonably ever expect to never touch. And so I've shared a lot here, and I hope the additional context is helpful, because I'm going to summarize here on when SMAs should be considered, but I thought it might be useful to see to what extent, not just should you use them or should you not.

23:20And so again, going back to who should consider SMAs, I think you have to have taxable assets that you don't plan to touch in your lifetime. I think another good use case is if you have a concentrated position that needs diversifying, or you own a business or you're regularly receiving stock options that are going to trigger capital gains. Basically, what I'm saying is that you have a use case to harvest losses. And then the third reason is if you need or want specific customization due to individual stocks or sector ETFs with meaningful capital gains, or you have specific ESG preferences. So looking at these three products side by side, you got mutual funds, the legacy product, useful in retirement accounts, some bond strategies, maybe some niche hedge fund strategies, although I'm really not a fan of those.

24:08ETS are going to be the workhorse for most investors. They're cheap, they're tax efficient, they're widely available. But the SMAs, I do think, have a place for a lot of investors, particularly those with larger portfolios, some customization needs, or some tax-sensitive situations. As I mentioned, costs matter. I think sometimes paying slightly more for the SMA can make sense if you're getting value of the customization and the tax alpha. Other times, the cheapest ETF is going to be the right answer. I think one interesting behavioral angle I haven't touched on that SMAs can be helpful with is people who like owning individual stocks.

24:44I mean, I've said this many times, picking individual stocks is risky and most people are going to underperform unless they get incredibly lucky. If they outperform, it's probably not skill. It is probably luck, despite what you might think. But with an SMA, I have come to see that people like seeing the actual names on the statement. You feel like you really own the stocks, whereas when you own an ETF, it doesn't feel like you own NVIDIA or Meta or Google or whatever. On the other hand, transparency cuts both ways. Maybe seeing the daily performance of individual positions can tempt people to tinker.

25:16I'm generally the type of person who believes the best portfolios are the most boring. So I think in general, when you're looking at where the industry's heading, Mutual funds are going to continue to decline outside of retirement plans. ETFs are going to keep dominating the flows. And SMAs are going to keep growing, especially as cost fall in technology makes them more accessible. I think two developments to watch as we think about the flows and the interplay of these different vehicles are 351 exchanges, which is a tax strategy that's gaining a lot of traction. And then the SEC share class exemption.

25:50Because if this happens, I think you're going to see mutual funds start to create ETF share classes, which would then make it possible for investors to switch into a different share class, but would also make the mutual fund share classes more tax efficient. The bottom line is that ultimately, the perfect portfolio isn't about picking one vehicle over another. It's about choosing the right combination for your situation, your goals, and your behavior. because in the end, the wrapper matters less than the discipline and intentionality behind your choices. As always, thank you for listening to The Long-Term Investor.

26:25If you enjoyed today's episode, the best way you can support the show is by leaving a rating or review in your podcast app. It only takes a minute, but it helps more people discover the show and join us in learning how to become better long-term investors. Thanks for listening to The Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan.