Personalized Managed Accounts: Putting Investors in the Driver’s Seat
Kevin Knowles is the senior director, personalized solutions for Russell Investments’ advisor and intermediary solutions business. Kevin is responsible for the management and development efforts of Russell Investments’ Personalized Managed Accounts (PMA) program, a suite of advisor-sold customized separately managed accounts (SMAs).
Nick Zylkowski is the director of Russell Investments’ Equity Proprietary Strategies team. Nick and his team are responsible for Russell Investments’ factor investing, tax managed, ESG and other systematically driven investment solutions.
I spoke to Kevin and Nick on October 4, 2021.
Russell Investments recently introduced Personalized Managed Accounts. Can you talk a little bit about that and what is being offered?
Kevin: Every investor’s needs and preferences are unique. And as an investor’s wealth grows, so do their expectations and the complexity of their investments – like tax management and environmental, social and governance (ESG) considerations. This is where Personalized Managed Accounts (PMA) come in.
You could describe PMA as the next level of customization. In the past, most investors were limited to a “one size fits all” solution where everybody invested in the same securities owned by a mutual fund or exchange traded fund (ETF). Some higher net worth advisors were able to directly own securities through separately managed accounts (SMAs) but the early SMAs didn’t have the ability to truly customize the client’s portfolio, so most people still owned the same thing. Fast forward to today: Using the same SMA chassis, changes in technology and distribution now allow a wider range of investors to take full advantage of that direct ownership feature and customize their experience in different ways. Direct ownership involves purchasing individual securities in your account. Rather than owning shares of a fund or ETF in which an investment is aggregated alongside thousands of other investors, a money manager will buy the individual stocks and bonds directly in an investor's brokerage account.
In essence, PMA is like a supercharged SMA: It provides for direct ownership of securities, allowing investors to choose individualized portfolios, but it also adds custom overlay and exclusion services (e.g., tax-managed overlay services and ESG exclusion and overlay options) and personalized transition management. PMA is a distinctive solution tailored to an investor’s specific needs.
Russell Investments’ PMA program features six SMAs. These include three actively managed equity SMAs, two direct-indexed SMAs and a core equity SMA, which combines both active and direct indexing. It’s been exciting to see this approach resonate with advisors. Because of the flexibility of these solutions and the scalability that makes them available to a larger portion of the population, advisors are quickly finding these products are a good fit for a broad range of client types and circumstances.
How does PMA allow you to customize the investor experience?
Nick: Tailoring the investment outcome to an individual’s unique circumstances involves customizing a range of variables. Each area of customization will be important to different individuals. Our PMA solutions allow significant customization of some of an investor’s major concerns:
Tax management. The most common customization investors are looking for is managing the tax liability associated with their investment portfolio. We have a heritage in this space with a range of mutual funds that focus on maximizing after-tax returns, and we continue to see growing interest in tax management. Changes coming out of Washington, DC, in addition to a long-lasting bull market, have led many investors to think more about the tax implications of their investments than they have in the past.
Whether an active or passive strategy, using a tax overlay in making trading decisions allows a manager to potentially reduce the tax burden of a portfolio and improve after-tax outcomes. Taking into account tax lot details, purchase dates and costs, which are unique to each individual investor, is critical for effective tax management.
ESG exclusions. Environmental, social and governance considerations are becoming an increasingly important factor for many investors. A wide-ranging set of ESG exclusions provide customization options to ensure an investor’s portfolio is aligned with their personal set of values or preferences.
Optimal transition planning. Transitioning from an existing portfolio to a target portfolio is not as easy as simply selling legacy holdings and buying new holdings – especially when taxes are a consideration. Careful transition planning enables investors to move assets between strategies while balancing the resulting tax liability. An immediate transition, such as selling all legacy holdings while buying a new portfolio, can often leave an investor saddled with heavy tax liabilities and worse off on an after-tax basis. By designing a transition plan to move between strategies over a set number of years or with a specific tax budget in mind, an investor will have a better after-tax outcome over the life of the transition. This is the most critical component as it avoids the counterproductive exercise of paying taxes to move into a tax-managed solution.
It is common for executives or long-term employees to have stock positions from their employers, received over years as stock options or grants. Often these positions will have a low cost basis and represent concentrated holdings based on the size of their overall portfolio. Having options to customize an investor's portfolio, by selling in a tax-friendly manner and not purchasing additional holdings in similar companies, can help balance out the overall portfolio’s risk and after-tax return outcomes.
Restricting stock positions. Individual investors can also elect to restrict purchases or holdings in individual stocks or industries. An individual may have various reasons for restricting certain investments: they may have similar large holdings in other portfolios, they may be restricted from purchasing stock of a company they work for or of a competitor firm, or they may have individual preferences they want expressed in their portfolio.
More than ever, employees are being compensated in company equity and are looking to diversify their entire portfolio, not just a single sleeve of it, so being able to exclude securities is critical.
What are the benefits of direct ownership?
Nick: In a commingled fund, everything is shared across all investors: Fees, tax liabilities, investment risks. In many ways, this can be a good thing, as economies of scale enabled high-quality investment solutions to be accessible to individual investors. But commingled funds limit any personalized investment objectives.
Let’s take tax liability as an example. In a mutual fund, any capital gains realized throughout the year are aggregated into a taxable distribution at the end of the year, regardless of whether those gains were generated through rebalancing or trading due to the redemption activity of other investors. In this scenario, an individual investor may owe taxes as a result of trading decisions that may have been made without their individual investment situation in mind. In direct-share ownership, by contrast, taxes at the end of the year are based on the trades made directly in the individual’s account – all securities bought and sold can be optimized to the investor’s unique situation.
The largest benefit from direct ownership is that you own the taxes generated from those securities. This allows you to determine when to take taxable income as opposed to being beholden to when the mutual fund decides you are going to take it.
Kevin: One size fits all has served investors well over the years, but if you wanted to exclude certain securities for whatever reason, there was no option to do so using mutual funds or ETFs. You had to find a product that came as close as possible to suiting your needs. This also led to more complexity for advisors as they had to determine which products best suited their clients. Therefore, advisors would ask prospects or clients questions such as, “Are you looking for growth?” or, “Are you looking for income?” or, “What is your risk tolerance?” The questions generally had to stop there.
With direct ownership, now the questions can be more like: “What industry do you work in – so that I know which areas of the market you already have exposure to? Do you have equity in your company we should build around? Do you have beliefs, either faith-based or strong personal preferences, that may lean you toward or away from specific types of companies or industries that I should be mindful of in designing and constructing a portfolio for you?” These questions bring a much more personal feel to investing. Direct ownership can solve for these circumstances and preferences, in addition to positioning for the traditional growth, income, and risk-tolerance questions. Not only that, but advisors can also utilize the same product for multiple clients with differing needs – making their job easier.
Individual investors today have a wide range of direct ownership investment solutions from which they can choose: from concentrated, active strategies that might buy dozens of stocks, to diversified, passive strategies that will buy several hundred individual stocks.
Russell Investments supports active management. But in your PMA program you include two passive direct indexing SMAs. Why?
Kevin: Active and direct Indexing each have their own benefits and objectives and can complement each other. The objective of the active strategies within PMA is to outperform a respective index, after-tax. The role of the direct indexing strategies is to track a specified index while providing net losses that can be used to offset gains in another part of a client’s overall portfolio. This is possible because indexes generally have no or very little turnover.
In contrast, with active management, turnover is inevitable. Money managers buy and sell securities in order to take advantage of market mispricing. When there is turnover in a portfolio, gains and losses are realized and even when managing those gains and losses to limit taxes as much as possible, it can be challenging to eliminate all taxes, particularly in strong bull markets. Having both direct indexing and active strategies gives advisors optionality for different client needs.
Given the complementary characteristics, an efficient approach is to actually combine direct indexing with active management in a single portfolio. This provides the most efficient tax vehicle with active management where residual gains can be offset with losses from direct indexing as well as the right asset allocation for the developed equity portion of their portfolio. Everyone’s situation is different, so advisors and clients need to find what works best for their goals, circumstances and preferences. This is what our PMA solution is designed to facilitate.
This is a different approach from most other firms in the SMA space, which generally utilize passive vehicles. What are the advantages of active management in this space?
Nick: There are several potential benefits an investor can expect from an active SMA relative to passive. For starters, active strategies will hold fewer names than a passive strategy, which allows for lower account minimums. For investors looking to create a diversified total portfolio, which can include international and small cap components, a lower minimum for each asset class helps those investors without multi-million-dollar portfolios still achieve an optimal asset allocation using direct-ownership strategies. Additionally, by leveraging stock selection insights from some of the best institutional money managers in the industry, as Russell Investments does, active SMAs provide the opportunity to outperform a passive alternative over time through skillful stock selection.
Pairing portfolio allocations with other asset classes enables an investor to build a total portfolio allocation that meets their risk and return objectives, leveraging direct ownership and a full range of customization options.
Does a lower security count matter? What benefits does that bring?
Nick: This does matter and there are many other important portfolio construction trade-offs to consider for active SMAs. Since many managed account portfolios are taxable, the number of securities, level of turnover and frequency of rebalancing are important in effective tax-managed implementation. If an active strategy cannot be implemented in a tax-friendly way, regardless of how great the returns are, after-tax outcomes will suffer, and this may be unsuitable for taxable investors. Russell Investments, through our decades of manager research and tax-managed investment experience, has researched these trade-offs in detail. Our active portfolios are managed with several design features that optimize the after-tax return proposition – both focusing on pretax return ideas and tax-friendly portfolio construction.
Can you talk a little bit about those design features?
Nick: We aim for a name count of 80 stocks, identified by high-conviction, active institutional money managers. Russell Investments uses stock inputs from multiple managers, taking advantage of high-quality stock insights. We look for balanced sector and country exposure, so that no one sector or country will represent an outsized risk to the portfolio. Total portfolio turnover is managed to a moderate level, typically 40-60% per annum, which helps reduce tax drag on the portfolios. And long-term holdings and positions are prioritized in the active model, helping avoid short-term gains and wash-sale tax issues.
One of the first objections advisors have to moving to a direct ownership model is the tax cost to switch. How does Russell Investments help advisors address the tax hit of transitions?
Kevin: There are several transition options available to advisors and clients. We have a team of analysts who can run robust, individualized scenario analyses to help advisors and their clients understand the pros and cons of each option.
One is a tax budget approach where the client indicates a tax or capital gain threshold they are willing to take on, including zero. Then there is a timeline-based transition, where clients can select three- or five-year transitions where we will move the portfolio to the target portfolio over time to spread out and hopefully limit the taxes incurred. The trade-offs are control of timing versus control of taxes. Individuals who select the budget approach have complete control of taxes, but the time it takes to transition is very market-dependent. The people who select the timeline-based approach have control over how long it takes to get into their targeted portfolio, but the taxes incurred are market-dependent. In either case, we do our best to work within the parameters we have to lead to the best tax and timing outcome we can for the investor.
Russell Investments has numerous tools to run a scenario analysis that considers actual holdings and any unrealized gain or loss in a client’s portfolio. An advisor simply sends over a set of holdings, tickers and shares along with the original purchase date and cost basis. Russell Investments will take care of the rest. We build different transition scenarios across time horizons and with fixed tax budgets, providing a summary back to the advisor. The advisor will be able to see what tax impact each scenario would incur over time, along with the estimated tracking error from the target portfolio. The transition analysis outcome has proven useful in helping advisors make informed decisions with their clients, with clarity into tax and tracking error trade-offs from moving between investment strategies.
It seems the benefits of direct ownership of securities always leads with tax management. Is direct ownership only for taxable investors?
Kevin: Not necessarily. For example, ESG is a hot topic today. The industry hasn’t quite figured out what ESG is. In fact, I would say the people who want ESG don’t quite know what they are asking for. For example, when people say they want to invest in green energy, what do they mean? Do they mean they want to exclude securities that have a carbon footprint, or do they want to invest in companies that are investing in green energy? The most likely answer would be “both of course,” but the world doesn’t quite work that way. What we have found is that what resonates best with investors is to have category exclusions in different categories such as carbon, controversial weapons, alcohol and tobacco, etc. This way investors can express their preferences by excluding securities they don’t believe in, and don’t need to think through the implications of investing in companies that oftentimes have environmentally conflicting businesses.
How do these exclusions and restrictions due to ESG or other concerns impact the investment outcomes?
Nick: As ESG and other exclusions get removed from the target portfolio an account will invest in, the account will realize a performance impact by not owning any restricted company. This is the outcome our clients would expect. As an example, if an investor chooses not to invest in tobacco stocks and tobacco companies underperform the benchmark, our client outcomes will be better off by having eliminated that exposure from the portfolio. In some cases, such as the example of wanting to support green energy, many investors see increased investment risk associated with high carbon emissions or with companies involved in other controversial industries. Their expectation when adding restrictions to these industries is that these risks will be removed.
The ability to tax-manage a portfolio still exists in the presence of ESG or other restrictions. With the exception of any initial liquidations, an investor should not anticipate a material change to their tax liabilities if they choose to include an account restriction.
Lastly, what differentiates Russell Investments' PMA from its peers?
Kevin: PMA allows investors to take control of their holdings while simplifying and streamlining their portfolio. PMA includes advanced tax management, customization for personal needs as well as personal wants, transition management as existing accounts or holdings are moved into PMA, right on down to transparency into the portfolio’s holdings and trading activity.
Mutual funds are a good option for most clients when tax management and customization aren’t needed. Tax-managed mutual funds step it up for clients with non-qualified assets where taxes are an important consideration. SMAs can be a great option for a lot of clients with specific needs. With PMA, advisors can provide their clients with a higher level of customization and comprehensive tax management all while targeting a specific outcome.
Important Risk Disclosures
Please remember that all investments carry some level of risk. Investment in one or more separately managed accounts is not a complete investment program and involves risk; principal loss is possible. The principal value of the account is not guaranteed at any time. There are no assurances that the objectives in this material will be met.
Diversification and strategic asset allocation do not assure a profit or guarantee against loss in declining markets.
Personalized Managed Accounts (“PMA”) is a program of Russell Investment Management, LLC (“RIM”) and offers customized portfolio management services.
Each Personalized Separately Managed Account is a product of Russell Investment Management, LLC (”RIM”) and is offered through PMA. It represents a composite of model portfolios provided by RIM, in which each composite reflects model portfolios of RIM and third-party investment advisors selected by RIM. When the model is implemented, PMA is a separately managed account program of individually owned securities that can be tailored to meet an investor’s investment objectives. RIM partners with external third-party money managers to offer diversified, single or multi-asset managed accounts that can be customized to the investor’s investment objectives, circumstances and preferences, such as (but not limited to), market exposure, risk management, tax management, environmental, social and governance considerations, and return objectives. Excluding any allocations to pooled investment vehicles, if any, each investor’s account is managed separately from other investor accounts, allowing for a personalized experience to deliver unique investment outcomes.
The decision to use PMA in investors’ portfolios and related investment advice are provided through financial advisors and other financial intermediaries that are independent of RIM and its affiliates. Investors should consult with their financial advisor to determine which services and programs are appropriate to meet their investment objectives.
A note about the transition approaches which may be featured in the transition analysis report:
The Timeline approach which moves the existing portfolio to the new strategy over a set number years, is available for all Personalized separately managed accounts (SMAs).
The Tax-Budget transition approach which moves the existing portfolio to a new strategy while limiting taxes or capital gains per year, is only available for: Personalized Core Equity SMA, Personalized DI Large Cap SMA and Personalized DI All Cap SMA.
Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.
Russell Investments' ownership is composed of a majority stake held by funds managed by TA Associates, with a significant minority stake held by funds managed by Reverence Capital Partners. Russell Investments' employees and Hamilton Lane Advisors, LLC also hold minority, noncontrolling, ownership stakes.
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First used: November 2021. RIM 02311