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Unreliable Narrators: What Many SMA Composites Don't Tell You

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Rey Santodomingo, Director of Investment Strategy - Tax Managed Equities, Parametric

      Seattle - The composite: It's the tool investors and their advisors most often reach for when evaluating asset managers. And for good reason—it can be a handy way to assess historical performance and thus compare investment products. But in their reliance on composites to narrate an investment product's key attributes, are investors always getting the full story?

      The answer is no—especially when it comes to taxable separately managed accounts, or SMAs. Because while it's relatively straightforward to use composites to assess pretax performance in SMAs, investors must be cautious when evaluating after-tax returns. There are three key factors that can affect an SMA composite's after-tax returns: cash flows, age of accounts, and construction methodology. Let's look at each of these factors to illustrate the reasons to be wary of composites when evaluating SMAs.

      Cash flows

      Generally, cash flows coming into a composite will have a positive effect on after-tax results, while outflows will likely have an adverse effect. The table below considers two hypothetical portfolios that fund at the same time, but one experiences cash contributions while the other doesn't. The portfolio receiving cash infusions will be able to purchase positions with a fresh cost basis, enhancing the possibility of additional tax-loss harvesting in the future.

      PPAsma

      Hypothetical performance is for illustrative purposes only. It assumes a 5% annual return with 35% security volatility. It does not reflect any investment strategy offered by Parametric. Tax alpha is the difference between a composite's after-tax excess return and its pretax excess return.

      This concept plays out on a larger scale when you consider the impact to a composite made up of accounts that all have different cash-flow experiences. One manager's composite of accounts may have received more net cash inflows than the other, perhaps as a result of receiving a larger percentage of cash-funded portfolios versus those funded in kind. It's nearly impossible to assess the magnitude of the impact this will have on a composite.

      Age of accounts

      Over time, especially in rising markets, it becomes relatively more difficult to find losses in a portfolio. This is caused by the underlying securities appreciating in value and by a reduction in the portfolio's cost basis due to loss-harvesting activities, and it's apparent when you compare the relative tax alpha of older and younger portfolios held in the same composite.

      For example, the increased market volatility we saw in December 2018 provided ample opportunities to harvest losses across many portfolios, regardless of their age. But younger accounts—those with less overall appreciation from the long bull market of the past decade—will naturally have more losses to harvest than older accounts.

      A composite that contains a larger percentage of newly funded accounts will thus appear to have higher after-tax returns than those of composites with a greater number of aged accounts. That's why, when evaluating the after-tax composite returns of different managers, investors must consider that the relative age of the accounts may skew the results and make for a biased comparison.

      Construction methodology

      When preparing a composite, a manager has some flexibility to determine which accounts to include. As a result, it's important to closely examine a manager's construction methodology to consider whether the composite includes:

      • Only portfolios funded in cash
      • Portfolios that experience large inflows or outflows
      • Accounts with restrictions or other client customizations
      • Portfolios whose owners have instructed the manager to realize gains
      • Portfolios that received in-kind contributions
      • Only tax-managed portfolios or a mix

      Each of these decisions could materially affect—in some cases to a large degree—a composite's after-tax returns.

      Asset managers create composites to reassure investors that their products have a proven track record. Past success doesn't guarantee future results, of course, but composites do tend to figure into investors' expectations of performance and risk.

      Yet as we've discussed here, composites for SMAs can be a black box. As a result, investors should be cautious about choosing an SMA provider based on composite performance. A more useful and clear set of metrics might be gained by evaluating other factors, such as the provider's tenure, technology, scalability, access to its strategists, advisor tools and resources, customization options, transition approaches, reporting capabilities, and so on.

      In a nutshell, can the SMA provider offer choices with regard to the amount of active risk taken in a portfolio, and can those choices later be adjusted as appropriate to better deliver on portfolio objectives? And can the provider also offer a range of implementation options for clients depending on their priorities?

      Bottom line: In light of composites' sometimes misleading nature, these are far more meaningful markers of an SMA provider's capabilities such as those discussed above.