Bonds

Shifting investor demands spark explosive growth of SMAs

The tremendous growth of separately managed accounts in the municipal market has been spurred on by higher yields, lower fees, the desire for deeper customization along with improvements in technology.

Some participants on the Street estimate that SMAs hold as much as $1.5 trillion of munis while others peg it closer to $1 trillion to $1.3 trillion.

Regardless of the total — and it is difficult to quantify it because of how they are reported — it is exponentially higher than the $100 billion that was estimated before the financial crisis.

While mutual funds have seen large outflows during 2022 and 2023, SMA, as well as exchange-traded fund, growth has bolstered retail investment in munis.

The “sheer amount” of capital that has flown into SMAs, especially in fixed income, and particularly in muni SMAs, is noteworthy and makes sense given the market conditions of the past few years, said Chris Brigati, senior vice president and director of strategic planning and fixed income research at SWBC.

“The amount of capital that is flowing in there, and the way that they’re engaging the market is decidedly different” than mutual funds, he added.

Once yields began to rise in 2022, it “encouraged people to think more broadly about how they can take advantage of those yields,” said Sylvia Yeh, co-head of the municipal fixed income team at Goldman Sachs, noting investors now have more choices, whether it be mutual funds, ETFs or SMAs.

Mark McQueen

Household ownership of individual bonds — which includes SMAs, along with direct ownership of individual bonds in brokerage accounts and fee-based advisory accounts — was at $1.63 trillion in Q3 2023, up $84.7 billion, or 5.5% from Q3 2022, according to the latest Federal Reserve data.

However, household ownership fell $67.4 billion, or 4% quarter-over-quarter. But those figures can be misleading because some of that household shift is likely individual investors moving into SMAs and ETFs.

SMAs were used before 2008 but grew more so after the financial crisis, as there was an increasing need for “professional credit selection,” said Steve McLaughlin, co-head of the municipal capital markets group at S&P Global Market Intelligence.

Compared to mutual funds and ETFs, which have perpetual maturities, SMAs help financial planners and their clients manage maturities and duration.

“We had market events along the way that forced these different vehicles to evolve,” said Sylvia Yeh, co-head of the municipal fixed income team at Goldman Sachs, noting the financial crisis, the Tax Cuts and Jobs Act in 2017 and the pandemic, among others were catalysts for innovation.

And then, recently, there were great opportunities for clients to invest in an SMA, she said.

Following the remarkably low yields of 2020 and 2021 — with record mutual fund inflows — the volatility in 2022 and 2023 marked an even further shift to the SMA.

The recent “pop” in yields made munis more exciting again, garnering attention from investors, Yeh said.

“That encouraged people to think more broadly about how they can take advantage of those yields,” she said, noting clients now have more choices, whether it be mutual funds, ETFs or SMAs.

This has led to many advisors trying to keep their client’s investment, and some of that is getting them out of cash and into strategies “that transition nicely into a longer-term focus,” such as SMAs, said Blake Lynch, head of sales at IMTC.

And it’s the customization, transparency and adaptability of SMAs that appeal to clients, along with their ability to express what is important to them, Yeh said.

SMAs have succeeded in the retail space as “advisors are focusing on scaling their business and adding value, said Nisha Patel, managing director and portfolio manager at Parametric.

“If you think about any wealth management, [registered investment advisors] or a bank’s wealth management arm, they want to continue to grow, and SMAs are a very scalable and efficient solution to do that,” she said.

“If you ask any client, they want customization, they want accounts that fit their profile and tax efficiency,” Patel said. “SMAs are the preferred vehicle to do that.”

As a result of the cash being put to work into SMAs, “providers are now looking into technology and how best to implement it to help them scale their business,” S&P’s McLaughlin said.

Technology has helped in terms of portfolio management, the ability to structure and maintain proper risk controls, and the overall trading of SMA individual positions, said Ben Barber, senior vice president and director of municipal bonds at Franklin Templeton Fixed Income.

That allows large managers, such as Franklin Templeton, to manage more accounts than it could have a decade ago, he said.

That ability has prompted more competition, which has, in turn, led to lower fees, Barber said.

Firms are either creating their aggregator for secondary offerings or using someone else’s to gather offerings in the easiest way possible, McLaughlin said.

Three years ago, S&P Global Market Intelligence, for example, rolled out a buy-side platform that helps all buy-side clients — SMAs, mutual funds, ETF, insurance companies and banks — manage the primary market, he said.

“That’s one choice to help buy-side accounts manage the primary market,” McLaughlin said.

Additionally, improved technology has made it easier to manage SMAs as various custodians can better communicate and the process has been streamlined, Lynch said.

“The market’s better, the technology is better, and everybody seems to want more personalization,” IMTC’s Blake Lynch said.

Clane Gessel/Clane Gessel

IMTC secured its first external funding round, led by venture capital company Nyca Partners, in 2022. At the time, the firm said it was focused on developing solutions that enable efficiency in managing SMAs.

In November, SEI, a global provider of investing and technology solutions, selected IMTC to assist in optimizing its fixed-income SMA management and expanding its product offerings.

“The market’s better, the technology is better, and everybody seems to want more personalization,” Lynch said.

The firm’s system creates a streamlined workflow that helps “you do it a lot faster,” such as managing hundreds of thousands of SMAs at scale, he said.

Furthermore, technology has led to the greater availability of different products, according to Barber.

Most of the muni SMA offerings 10 to 15 years ago were “high quality, plain vanilla ladder SMAs,” but now there is greater product differentiation largely due to technological improvements, he said.

Franklin Templeton’s products range from “plain vanilla, high quality” to credit spread types of SMAs, including a full CUSIP-only high-yield muni SMA, Barber said.

With the ups and downs of the market, a single portfolio manager can better handle the volatility for that individual client than somebody in a mutual fund, according to Brigati.

For example, the “big shifts” at the end of 2023 may have led investors in an SMA portfolio to see a net loss on their fixed-income portion due to their ability to take advantage of higher interest rates. However, that loss can be offset with gains in the equity market, he said.

Mutual funds, though, are not looking to take tax losses for all investors in the fund, Brigati said.

Mutual funds and shifting investment strategies
SMAs represent a “major” shift in the asset base, which has been occurring over the past 20 years but was more acute during the 2022 redemption cycle from open-end mutual funds, Barber said.

While some of that money is still sitting in cash and cash equivalents, a “huge portion” of the money returning to the muni market went into SMAs, he said.

There has been anecdotal evidence of money leaving mutual funds for SMAs and ETFs, though there are no exact figures.

Mutual funds were at $727.2 billion in Q3 2023, down 6.1% or $47.1 billion year-over-year. Meanwhile, ETFs rose 24% in Q3 2022% year-over-year, increasing $20.9 billion to $107.9 billion, according to the latest Fed data.

Mutual funds saw massive outflows in 2022 and continued, albeit to a lesser extent, in 2023.

LSEG Lipper reported outflows of $66.65 billion in 2022, while ICI reported outflows of $145.16 billion.

Historically, after a year of large outflows from funds, the following year tends to see a rebound. That did not happen in 2023.

Outflows continued in 2023, with LSEG Lipper reporting outflows of $8.6 billion in 2023, while ICI reported outflows of $21 billion.

Mutual funds have started off on a more positive note this year with LSEG Lipper reporting $2.6 billion of inflows into muni mutual funds year-to-date, while the Investment Company Institute reporting $4.4 billion of inflows.

Patel said it’s not surprising that there have been inflows into muni mutual funds after two years of outflows.

While she expects net inflows into mutual funds and munis to end 2024 on a positive note, that will not stop inflows into SMAs.

Additionally, some of the money heading into SMAs comes from cash where investors’ long-term plan was to put it in bonds anyway.

Parametric, for example, has seen a record month for assets coming into fixed income, signifying money is moving into fixed income with the Federal Reserve’s tightening cycle ended, said Patel.

Investors are looking to lock in yields, but they want to do it in “this preferred vehicle of SMAs,” Patel said.

There are some drawbacks to SMAs, sources say.

SMA assets generally require a higher par amount per investor to participate, according to Brigati.

For an investor with $100,000 to put into the fixed-income portion of their portfolio, he said, it’s tough to get SMA diversification. In that instance, he said, a mutual fund or ETF would make more sense.

But when investors have assets north of $500,000 in a fixed-income portfolio, that allows for “good” diversification in a customized portfolio as opposed to the specific duration of a mutual fund, he said.

“That allows [investors] to have a better, more focused, bespoke customer experience that suits their needs much more directly,” Brigati said.

Additionally, there may not be as much liquidity in an SMA “because you’re buying an individual bond position,” Patel said.

Mutual funds and ETFs are “fairly liquid,” compared to a $250,000 account and smaller par sizes with an SMA, “there may be a slightly steeper discount” if you had to liquidate all the positions given the nuances of the muni market.

It can also be difficult for clients to get their money invested as quickly as they may like, Brigati said.

If a client puts money into an SMA and is fully invested after a year, the individual has to “go through the typical cycle of maybe a bond matures and/or you have coupon payments, and you have to reinvest those proceeds back into the market,” he said.

However, for the portfolio manager, Brigati said, it can be tougher and longer to get those funds directly reinvested.

“The portfolio manager has hundreds of accounts that probably are in the same situation, so they’re trying to manage through that process of getting all those funds reinvested at the same time,” he said.

Despite these barriers, SMAs are the fastest growing portion of the market and will continue to be so, market participants said.

Another benefit of an SMA is “because they’re becoming easier to manage operationally, I see a lot of growth in the space,” Lynch said.

More firms are offering internal warehouses where SMA managers can post their strategists, allowing advisors across the country to tap in and access those advisors.

“It’s opening the door for more types of SMAs and great accessibility of SMAs,” Lynch said.

Part of that growth of SMAs will continue to be in differentiated products, Barber said.

“Very plain vanilla products” are still important and will continue to have a place in the SMA space, he said. However, more differentiated products, such as more credit exposure and more customization on the tax loss harvesting side and tax efficiency side, will see strong growth, he said.

“The growth of SMAs have been hot and heavy in the past decade, and that’s while rates were at their lowest,” McLaughlin said. “So now that rates are in a more historical band, you should see more allocation to the asset class via SMAs.”

“Whether it’s with an innovation or technology … we’ll continue to make SMAs more appealing and more widely available to different types of clients in the future,” Yeh said.

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