By Don Wilkinson
DFW & Associates, Inc.

There's a cycle that occurs approximately every four years as capital gains build up in investors' accounts. In tax year 2000, for instance, investors were subject to low performance in many mutual funds - especially high-tech stocks. At the same time, these investors got hit with excessive capital gains taxes. The same thing occurred during the 2003 thru 2007-tax period.

You would think that mutual fund investors getting smacked twice - less than stellar performance and capital gains taxes - would have them looking for a better way to accumulate wealth.

There is a better financial investing strategy that can offset the mutual funds' tax nightmare. Investors with taxable mutual fund assets have been hammered with the double whammy for years now should investigate setting up a separately managed account (SMA). Reducing taxes may be the strongest reason you have for making a separate account a part of your investing strategy.

Reduced Taxes Translate Into Gains

Switching to a separately managed account will generally help you reduce your tax burden by 2 percent to 2.5 percent. That can add up to a lot of money reflected in your ROI.

Mutual funds can nick you in other ways too. No investor wants to be a victim of phantom gains. These are gains realized by mutual fund holders who enter a fund late in the year and end up owing the IRS for capital gains before they even have the chance to participate in positive returns that were made before they purchased the fund.

In a separate account, you can avoid getting hit with severe capital gains taxes each year by assigning responsibility for minimizing your tax burden to your assigned money manager(s). Your money manager(s) can perform "tax-loss harvesting." Tax-loss harvesting is the practice of selling holdings at a loss to offset gains elsewhere in a portfolio. Harvesting is often done while reinvesting in a security with characteristics similar to the investment that has lost value and consequently is being sold. This practice lowers an investor's tax liability without changing the risk profile, sector or strategy of the managed account.

Tax-loss harvesting is not possible with most mutual funds, as they are owned by a pool of investors, not individuals.

Skilled trading - not excessive trading - keeps costs low. Excessive trading generate high trading costs and capital gains. This saps after-tax returns in mutual funds.

If you set up your own separate account, excessive trading that causes bounce-back tax bills will no longer be a critical concern. Separate accounts money managers do not trade out funds routinely after a person's long-term investing strategy is determined. On the other hand, the average yearly turnover of a U.S. mutual fund is around 90 percent. No mutual fund investor has control of how often his fund's stocks are traded.

With a separate account, you own the stocks in your portfolio. You can be in sync strategy-wise with your financial advisor and preselected money manager(s) who can sell under-performing stocks on a systematic basis to offset capital gains.

Separately Managed Accounts have been around for 30 years or more and have been utilized discreetly by ultra-wealthy investors, corporations and institutions as the ultimate means of managing big money. From its original concept, SMAs have utilized the services of top-level institutional money managers managing client portfolios valued in the millions of dollars.

The Plus Side of the SMA

SMAs offers a host of benefits that mutual funds do not. Besides the ability to minimize capital gains tax liability through tax gain/loss harvesting, SMAs offer customized portfolio holdings, open management choices, and a fee-only pricing structure.

The SMA can be called a "personal" mutual fund. Instead of being in a pool of thousands of investors in a mutual fund, the individual owns his/her securities. Further, the investor retains the option of rebalancing his/her portfolio executed by his advisor and pre-chosen professional institutional money manager(s).

SMAs are widely heralded for their flexibility. A participant can ask for certain securities to be excluded - say, he/she owns a large amount of company stock. Also, investors can ask for certain tax planning moves, such as taking losses to offset capital gains. This type of customization isn't possible for mutual fund investors.

SMAs have been building up assets rapidly. So much so, their use is spreading beyond the big wire houses like Morgan Stanley, Merrill Lynch and others who have 73% of the business to regional brokers, banks and insurance companies. Independent financial advisors have been launching SMAs as viable options for their more affluent clients.

If you look at the numbers, total SMA assets posted a record $1.5 trillion during 3Q 2007, according to the latest data published by the Money Management Institute, the association for separately managed accounts.

Past Disadvantages of Separate Accounts

One of its major strengths, the SMA was designed for individuals whose portfolios are serviced by professional money managers - top experts in their field specializing in specific asset classes.

That can be a negative because each asset class with the traditional separate account requires a separate money manager. This could mean an investor could retain a number of separate accounts, each with their own monthly statement, trade confirmations and each with their own account minimums.

See where "separate" comes in with "separate accounts"? What if an investor seeks to build a diversified asset management portfolio? He/she desires 50% equities and 50% fixed income. To construct this portfolio using separate accounts, the investor with his advisor would have to open two separate accounts - one by a money manager specializing in equities and one specializing in fixed income. Not only would this increase minimums (example: $100,000 per asset class required to cover our simple model of only two asset classes) but it would also generate increased reporting procedures and paperwork.

Since separate accounts are, well, "separate," there may be little coordination between money managers over the portfolio. This could result in a duplication of holdings, and could even result in one manager buying a certain security at the same time another manager is selling it.

Additionally, separate accounts include major assets in equities and bonds, but are limited in the foreign market area and do not include financial strategy options such as open-ended mutual funds and/or exchange traded funds (ETFs).

The UMA: Variety of Asset Management Options With a Single Account Structure

Enter the third level of SMAs: The unified managed account (UMA). This is a fully integrated asset management system in a single account.

The UMA, which has all the positive aspects of the traditional SMA - regularly rebalanced, reduced tax liability, etc., but also can encompass most other investment vehicles (e.g., mutual funds, stocks, bonds, ETFs, hedge funds and more) in an investor's portfolio - all in one single account.

A UMA offers ease of administration for the investor and the advisor. Each investor requires one set of paperwork and all holdings are summed up in a single performance report. Portfolio management decisions are easy to coordinate and the account's asset allocation can be easily identified and monitored.

Customization, a benefit of the traditional separate account, allows the UMA ability to have all of an investor's assets into a customized asset allocation. This creates a diversified, tax-efficient account that offers systematic rebalancing and monthly checks if necessary, say for a retired investor.

The UMA also eliminates duplication by traditional separate account managers. Overlay managers oversee the UMA account, giving it an extra layer of tax management over the traditional standalone SMA.

The Model Portfolio: A New UMA By-Product

There is also a new concept called the "model portfolio". They are programs in which an asset money manager hands over the portfolio completely to an overlay manager. Overlay managers can be third party providers or in some cases, major distributors such as brokerage firms or banks.

In this type of program, the asset manager no longer manages the assets of the portfolio. As a spin-off of the UMA, the model portfolio is expected to increase the use of customization and tax-efficiency of SMAs.

With such UMA innovations, the investor will receive the management benefit of commingled vehicles, which may be most advantageous for his or her financial strategy. The tax benefits offered by the traditional separate account will still be in place. Further, the UMA offers the investor a more reasonable fee structure over the traditional separate account required minimums.

The UMA is still in an embryonic stage, but is currently available through third party platforms called TAMPs. Independent financial advisors mostly utilize these resource platforms.

The Household Managed Account: The Next New Thing

A future evolution of the UMA is the Unified Managed Household (UMH). The UMH will further revolutionize portfolio management by enabling a single account to span across financial institutions, across a family or household, as well as include an investor's assets held outside an institution, such as real estate or collectibles.

The UMH is considered the highest level of managed-account integration and consists of multiple accounts with multiple registrations across multiple financial organizations - allowing for coordinated professional management within and across accounts.

The "Family Office" for Mainstream Investors

In spite of the complexity, the UMH concept should be fully developed by the end of the decade and will give investors, managers and advisors a complete view of a family's financial picture.

The UMH has tremendous potential. It will give households a better sense of their entire net worth, their assets and how those assets are invested. Taking this step further, investors will better understand how their assets are being used, how they are diversified, and what exposure and risks they have. Their advisors will have the same knowledge. At the end of the day, knowing his or her entire so-called "pocket book" puts the investor in charge of his or her financial destiny - and the named financial advisor in a better position to advise. In fact, one of the major goals of an UMH account is to be able to read the investor's net worth on a daily basis.