SMAs become latest fund format to appear on ETFs’ menus

The ballooning exchange traded fund industry is threatening to take a bite out of separately managed accounts, having already eaten the lunch of the mutual fund sector.

Since the start of 2021 mutual funds have suffered outflows of more than $1tn in the US even as flashy upstart ETFs have pulled in $2tn, according to figures from Morningstar. ETFs have also gained market share in Europe and Asia, albeit at a slower pace. This has prompted a flurry of mutual fund-to-ETF conversions as asset managers have pivoted towards the ascendant fund structure.

Now some in the ETF industry are turning their gaze towards SMAs, hitherto another fast-growing segment of the $120tn global asset management industry.

London-based white-label ETF issuer HANetf recently completed what it believes is the first SMA-to-ETF conversion in Europe. This piggybacks on a nascent trend in the US, where Tidal Financial Group and Goldman Sachs have also conducted similar conversions on their ETF platforms.

“It’s been going on for a couple of years now [in the US]. It really got everyone’s attention early this year when Eagle Capital Management had a more than $1bn conversion [via Goldman],” said Jeff Tjornehoj, senior director of fund insights at Broadridge, a fintech consultancy.

“That something so large could happen [surprised people].” The prevailing view was that “SMAs were doing quite well and didn’t really need disrupting”, Tjornehoj added.

“I think we are at the beginning of this trend”, added Eric Hewitt, chief investment officer at SS&C ALPS Advisors, a boutique investment manager, who said many of its registered investment adviser clients were still not even aware SMA-to-ETF conversions were possible.

SMAs are professionally managed customised diversified vehicles that offer a personalised investment approach tailored to an investor’s goals and preferences. They are popular with wealthy investors, serving individuals or groups of people such as families.

They have grown rapidly in recent years, with assets in the US alone jumping from $952bn in 2017 to $2.2tn at the end of last year, according to Cerulli.

Despite this growth, some managers of, and investors in, SMAs now appear to be eyeing up the ETF option.

HANetf’s initial conversion was of an SMA managed by Lloyd Capital, a Swiss wealth manager, on behalf of a Mexican family office. It spawned two ETFs: the Lloyd Focused Equity Ucits ETF (FEP) and the Lloyd Growth Equity Ucits ETF (GEP).

Hector McNeil, co-chief executive of HANetf, said Lloyd Capital “had a couple of reasons to do this”.

One was tax related with, for instance, Irish-domiciled Ucits ETFs paying a discounted 15 per cent withholding tax on US dividend income, something “that you wouldn’t get through a segregated mandate”.

The second was that ETF conversion allowed Lloyd to create “a centralised offering”, opening the door to smaller clients and attracting external money that would not have access to an SMA, helping provide economies of scale.

According to McNeil, the two ETFs, with combined assets of $324mn have attracted $5mn of third-party money, since launch in May.

McNeil said HANetf was now in discussions with a big UK wealth manager looking to unitise their existing SMA-based investment proposition because “they have so many managers that go off-piste,” potentially inviting unwanted regulatory scrutiny.

In the US, tax has been the primary driver: as with mutual funds, SMAs in the US have to pay capital gains tax on winning positions every year, whereas ETFs’ unique trading structure often allows them to sidestep these liabilities, with investors in many cases only paying tax when they sell their holding.

“The SMA can be pretty tax inefficient whereas the ETF in the US can be ridiculously tax efficient. Most investors welcome that,” added Mike Venuto, co-founder and chief investment officer of Tidal Financial Group, the world’s largest white-labeller with about 130 ETFs, including the $18mn Days Global Advisors Absolute Return ETF (HF), which converted from an SMA earlier this year.

Hewitt said he was hearing from RIAs running SMAs that a lot of investors are “stuck” in that they are sitting on large capital gains and “at some point the decision making shifts from optimal [investment] exposure to managing the tax exposure”, a scenario that ETF conversion can help ameliorate.

Tidal says it is currently in discussions with about 50 RIAs about either converting SMAs to ETFs or launching ETFs that duplicate the strategies of their existing SMAs.

An SMA sporting unusual customisation might struggle to find a wider audience as an ETF, however, so one option was simply for only the non-customised parts to undergo conversion, Venuto said.

There are potential downsides, though. Conversion to an ETF would force SMAs to follow diversification rules, Tjornehoj said, while ETFs cannot hold private placements or other illiquid products.

“There is also some cachet as an SMA client,” he added, with some wealthy investors perhaps looking down their nose at a product that anyone can buy.

Tjornehoj believed the pace of conversions would be slow, “maybe five [this year in the US], and maybe twice that in 2025”.

Likewise SS&C, despite “a lot of inquiries from our clients”, did not expect the nascent trend “to impact the growth of SMAs”.

McNeil foresaw further conversions in Europe, however. 

“It’s definitely something that is resonating with people [in the US] and what happens in the US in the ETF space usually comes to Europe,” he said.