Aiming Downmarket

For years, reps have been told that separately managed accounts (SMAs), were being The institutional-quality management, tax efficiency, transparency and customization that had made SMAs so popular among high-net-worth individuals would be available to ordinary investors. This prediction has come true sort of. Thanks to technological advances and the introduction of multimanager products (so-called

For years, reps have been told that separately managed accounts (SMAs), were being “democratized.” The institutional-quality management, tax efficiency, transparency and customization that had made SMAs so popular among high-net-worth individuals would be available to ordinary investors.

This prediction has come true — sort of. Thanks to technological advances and the introduction of multimanager products (so-called multidiscipline accounts, or MDAs), advisors can now put clients into managed accounts with as little as $25,000. And, between MDAs and Morningstar ratings for SMA managers, it's becoming almost as easy to sell SMAs as it is to sell mutual funds. In fact, the MDA programs may even be simpler, because they offer a wide range of prefab asset allocations.

Easy, except for one thing: Most clients are not clamoring for these products. And many financial advisors are not pushing them. “It's difficult to explain to our clients that SMAs are more than sizzle,” says Chandler Taylor, a financial planner at the Moneta Group, an independent financial planning outfit in St. Louis. Taylor is one of the few planners in his firm who sells SMAs, and even he favors mutual funds for most clients. “For the average wealthy investor who doesn't have a concentration issue, I can't see that there's much more benefit than funds,” he says.

Hunters and Gatherers

But there is a big potential benefit for brokers: Those who are working the SMA angle are gathering more assets. The Money Management Institute (MMI) estimates that while only 15 percent of advisors use SMAs, that exclusive group has been bringing home the bacon — SMA assets have swollen from $339 billion in 1999 to $576 billion in 2004. That's an average growth rate of 11 percent. But the rate accelerated to 17 percent annually between third-quarter 2003 and third-quarter 2004. The Boston-based research firm TowerGroup estimates that growth will reach 18.5 percent this year, and, at that rate, SMA assets will reach the trillion-dollar mark in 2007.

Those reps are, for the most part, selling SMAs the old-fashioned way — to wealthier clients. But, there are other factors at play. Baby boomers, the oldest of whom are about to move into their 60s, are moving retirement account assets into SMAs. “The retirement market is a very big part of the business,” says Norm Nabhan, managing director of Smith Barney's consulting group.

Just how big is it? At the end of 2003, 45 percent of the $500 billion in SMA assets were held in IRA accounts, according to the MMI. Additionally, 25 percent of net flows into SMAs are coming from IRA rollovers. Not only that, but by 2008, Boston-based Financial Research Corp. expects that $2 of every $5 that goes into SMAs will originate from an IRA rollover. The IRS is doing its part to push the SMA industry, as well, recently saying that clients can now deduct the SMA fee from an IRA account as long as the client, not the account, pays for the fee (see a related story on page 32). This is not true of mutual fund fees.

At first glance, an investment vehicle that counts tax management as a core benefit would seem a strange fit for tax-deferred retirement accounts. “The tax benefits of the SMA do disappear,” says Matt Schott, an analyst with TowerGroup. However, the other benefits of the SMA — customization, transparency — remain intact. And, Schott says that when it comes to making distributions out of a client's IRA, a properly managed SMA may give you better results in the long term.

The Big Three

Scott MacKillop, co-founder of Trivium Consulting, a managed accounts consultant in Denver, says that the three virtues of SMAs will continue to attract clients: tax management — the ability to harvest losses to offset gains; customization — avoiding “sin” stocks, or tailoring portfolios to avoid overconcentration; and transparency — clients and advisors can see the entire portfolio, trades and fees. Also, he says, fees are competitive — and sometimes better — than mutual funds for larger portfolios. “Generally, the range of the total fee is between 125 and 250 basis points, but it can go as low as 1 percent depending on the amount of assets,” says Schott. Taylor says he can get fees as low as 65 basis points by using institutional mutual funds, but then it's a matter of buying across the firm.

And, despite its slow start, democratization will drive more SMA sales, the market watchers say. Jim Pupillo, a Smith Barney rep who got his start with SMA pioneer E.F. Hutton 18 years ago, says the process is very apparent in his practice. When he started selling managed accounts, the minimum was $1 million and — “And that was before style analysis and asset allocation became buzzwords — you got one manager, who was a good stockpicker, that was it.” Today, some multimanager SMAs have minimums as low as $25,000, and the average minimum for a single-manger SMA is around $100,000.

Pupillo says he now uses six or seven managers, with minimums ranging from $50,000 to $100,000, to give his clients complete diversification. Pupillo says SMAs make up roughly 95 percent of his $800 million book. For his best clients — those with million-dollar portfolios — Pupillos says he gets fees that are below those of no-load mutual funds. He also saves the client heaps come April. “High-net-worth folks already have huge tax bills because of taxable assets like multiple homes — I've saved clients from writing $100,000 checks to the IRS by harvesting losses to offset gains,” he says. “In a mutual fund your ultimate tax burden is at the mercy of the fund at the end of the year.”

But Pupillo is hardly the industry norm. According to Spectrem Group, 75 percent of full-service brokers who deal in SMAs use three or fewer managers. And customization and tax management are often left out of the mix: Spectrum found only 18 percent of full-service brokers customize their SMAs.

The Great Divide

At what point, or asset size, do SMAs make sense for clients (and their advisors)? It depends upon whom you ask. Randy Bullard, president of Placemark Investments, a Boston-based company that is a leading provider of outsourced overlay portfolio management, recommends traditional SMAs for clients with $500,000 to $1 million to invest, assuming that the assets will be parceled out in $100,000 chunks to managers in different disciplines.

On the other hand, Weston Wellington, vice president of Los Angeles-based Dimensional Fund Advisors (DFA), believes the entry-level threshold for SMAs should be more like $15 million. DFA takes what Wellington calls a “passive” approach to money management, which hinges on spreading investments over thousands of different stocks (as opposed to the 50 or 100 stocks in some SMAs).

For smaller clients, the route to SMA benefits (or at least some of them) is through the multimanager MDA products. Also known as multistyle portfolios, these programs are essentially funds of SMA funds — a collection of three or four managers covering different styles. Typically, tax management is still a benefit, but customization is more limited. And asset-allocation strategies are limited to a set number of models, as is the number of managers available to the program.

Albeit slowly, MDAs are doing their democratization thing, bringing SMA money management to more investors. Tracy Gallman, vice president of advisory consulting services at LPL Financial, says that after a year in operation, LPL's MDA program accounts for 20 percent of asset flows into SMAs.

Smith Barney's Nabhan says that assets in his firm's MDA program make up roughly 20 percent of total SMA assets at the firm, but that is rapidly rising. “They're popular because the FCs and clients understand they're getting greater diversification,” he says.

“They're the most important growth driver in the industry and they're driving down the SMA market further — you now can have one ticket for $200,000 spread across three managers and still be profitable,” says Dave Haywood, an analyst with Financial Research Corp.

It also retains the cachet of the SMA, a powerful force for many investors. “There's definitely a snobbery among some people with SMA products. I have clients that simply refuse mutual funds, no matter how appropriate, because those are for the ‘commoners,’” says one Raymond James advisor.

The Simple Life

Overall, says Schott of TowerGroup, the MDAs are “a simpler sale.” Even with lower minimums, single-manager SMAs are complex — the advisor must choose the right managers to get the right asset allocation and open an account for each SMA manager. After the sale, the advisor has to monitor each manager and rebalance allocations as needed. The MDA, by contrast, Schott says “is much more advisor friendly.”

Len Reinhart, chairman and founder of Lockwood Financial Group, a major independent distributor of managed accounts, says firms could be pushing the MDA concept for another reason: “I think many of them are pushing MDAs because they feel more comfortable that the management is being properly done by a manager overseeing it all,” rather than trusting the reps to do that time-consuming work. Also, they leave advisors to do what the firm counts on them for: bringing in assets and cultivating relationships.

In the meantime, the debate about what's right for the client — ETFs and mutual funds, SMAs or MDAs — will be decided by each advisor for each client, says MacKillop. “If I were an advisor I'd compare the fees and then, based on the client's situation, make a decision. They're all good products, just different, and it's going to vary for every person.” That said, says MacKillop, if you've got high-net-worth clients you should be looking into them if you haven't already. “Why? Because your competition is.”

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