Custodian debuts U.S Trust's actively managed index portfolio. Schwab Institutional is bringing U.S. Trust’s Tax-Efficient Structured Equity (TESE) strategy to the independent advisor space. Registered investment advisors (RIAs) who custody with Schwab now have access to U.S. Trust index portfolios that track the S&P 500 and allow for active tax management. Industry participants say that tax-aware indexing can add value as a core holding or as an aid to diversifying concentrated portfolios.

“Advisors are excited about getting this product,” says John Morris, head of Schwab’s separately managed account (SMA) business. TESE is available to RIAs through Schwab’s “Managed Account Affiliates” program of U.S. Trust offerings, which got off the ground earlier this year. U.S. Trust is a subsidiary of Schwab.

What you keep

A TESE portfolio consists of about 275 large-cap stocks chosen and sector-weighted to replicate the performance of the S&P 500. U.S. Trust managers take advantage of capital-loss rules by selling securities that have declined to generate real tax losses that offset gains made inside or outside the portfolio.

To illustrate the importance of managing taxes on gains, U.S. Trust product specialist Ken Lassner points to a study by Lipper that shows the mutual-fund universe losing nearly 20% of its gains to taxes over 10 years through 31 December 2004. “As we like to say, it’s not what you make that’s important; it’s what you keep,” says Lassner.

“As a core strategy, TESE gives you a cheap way to get core-equity exposure, or beta,” Lassner explains. “It can also [confer] portable tax alpha, because losses [in TESE] can be applied to [alpha-seeking] satellite gains.” Beta is the measure of an investment’s risk in relation to a specific market or benchmark. Alpha refers to the risk-adjusted performance of an investment in relation to a specific market or benchmark.

TESE can also help diversify a concentrated stock position as part of an exit strategy along with a pre-paid variable forward, says Lassner. In that strategy an investor sells all or part of a concentrated position, typically deliverable in two to ten years. The seller, who generally receives between 75% and 90% of the position’s current market value, retains a portion of gains made on the position over the period of the sale and protects the downside. With the proceeds from the forward sale invested in a TESE, the seller gets index-like equity exposure and the ability use the capital losses the TESE generates to offset a portion of the capital gains from the ultimate sale of the stock at the end of the forward contact.

Contenders

Scott Welch, a managing director of Rockville, Md.-based Lydian Wealth Management, says that Lydian is “a big fan” of active indexing. “And they’re becoming increasingly popular” with investors and managers alike, he notes. In addition to U.S. Trust, other active indexers include Parametric, State Street, Mellon and IXIS, which recently got into the game through its new Active Investment Advisors affiliate. And many others are getting ready to fight for market share, adds Welch.

That makes sense in a world where active indexing takes in a 22% share of institutional assets and 11% of mutual funds, according to Steven Schoenfeld, Northern Trust’s head of quantitative management and author of the 2004 book Active Index Investing.

Though active index investments account for just 1% of separately managed account (SMA) assets, Morris says it was advisor demand that prompted the introduction of TESE to Schwab’s “Affiliates” program. “We listen carefully to our advisors,” he says. “Many of them use passive strategies for the core of their portfolios, but they’ve been asking specifically for TESE to get the risk and performance of index funds along with the tax intelligence of a an active strategy.”

In addition to giving RIAs access to TESE, Schwab is making it cheaper for their clients to use. Its $500,000 investment minimum stands to make it an easier sell than it would be as a direct investment with U.S Trust, where investment minimums hover at around $2 million.

With a 67% share of the market at the start of 2004, Schwab is the biggest RIA service agent out there, according to Cerulli Associates, a Boston-based research firm. About 20% of the roughly 5,000 advisors who custody assets with Schwab use managed accounts, says Morris.

“Managed Account Affiliates” is one of three Schwab SMA programs. “Managed Account Select” is an approved list of separate account managers, and “Managed Account Marketplace” an open-architecture platform with hundreds of participating managers. Schwab’s SMA programs took in over $1 billion in net flows in the first four months of 2005. –FWR