The Investment Cocktail

Separate accounts or mutual funds? The choice can be difficult, and often advisors feel compelled to pick one and ignore the other. Indeed, until recently, the case against mixing two investment types in the same portfolio has been a potent one. Hybrid investment portfolios historically have resulted in a host of administrative headaches, including extra paperwork and a new matrix of fee calculations.

Separate accounts or mutual funds? The choice can be difficult, and often advisors feel compelled to pick one and ignore the other.

Indeed, until recently, the case against mixing two investment types in the same portfolio has been a potent one. Hybrid investment portfolios historically have resulted in a host of administrative headaches, including extra paperwork and a new matrix of fee calculations.

But thanks to the proliferation of unified managed accounts (UMAs) — platforms that make it easy to include a complete array of products, including mutual funds, separate accounts, exchange-traded funds and hedge funds — the hurdles are no longer so high. Leaders in developing streamlined platforms include Smith Barney, American Express and Lockwood Advisors.

Stop ‘N Shop

Unified platforms provide clients with consolidated statements and enable advisors to monitor the portfolios and rebalance quickly. Smith Barney launched its integrated system in October 2003 and has $600 million in assets in the new program. Freed from many bureaucratic restraints, Smith Barney advisors are now able to pick and choose from a wide range of investments. For some clients, separate accounts are the best choice, while other portfolios focus on funds or ETFs.

“We look for the best solution, and we are willing to use any combination of investments that works,” says Jim Pupillo, a Smith Barney financial consultant and senior vice president in Scottsdale, Ariz.

The Smith Barney advisors can use the firm's integrated system to run screens, looking for choices with, say, top five-year returns and high Sharpe ratios. Armed with the resulting data, advisors can compare separate accounts, actively managed funds and ETFs.

For large-cap core holdings — where many choices boast similar track records — Pupillo often recommends separate accounts, which offer important tax advantages for clients with sizable portfolios. With a separate account, the investor owns each stock and can sell holdings to book losses. That red ink can be used to offset gains. In contrast, shareholders in mutual funds have no control over their tax bills. All too often, funds deliver big capital gains tax bills in years when investors least desire them.

Despite the advantage of large-cap separate accounts, not all investors want them exclusively. Concerned about expenses, some Smith Barney clients seek to use low-cost index funds for at least part of their portfolios. One approach is to put half the large-cap allocation into an actively managed separate account and half into an ETF, such as iShares S&P 500, an index fund. With that combination, the investor has a chance to beat the index. Also, the client gets low expenses and faces limited risk that the portfolio will deviate much from the index.

Old Friends

Instead of ETFs and separate accounts, some clients prefer the familiarity and flexibility of mutual funds. Many top mutual funds have well-known managers and long public track records. And while separate accounts have minimum investments of $100,000 or so, mutual funds often come with minimums of $2,000 or lower. In addition, mutual funds cover many narrow niches that separate accounts and ETFs ignore. A client who wants to own small international stocks or high-yield bonds may have no choice but to use a mutual fund.

Using a mix of mutual funds and separate accounts can be the right recipe for bond clients, says Joel Davis, senior financial advisor for American Express Financial Advisors in Augusta, Maine. Davis fears interest rates are about to rise, which would punish shares of many intermediate-term bond funds. To minimize the damage, he is using separate accounts that hold ladders of bonds. These portfolios include bonds with maturities of three years, four years and so on. If interest rates rise, a bond will mature soon and cash will be available to invest at higher yields. And because the portfolio holds bonds until they mature, the investor is guaranteed to get his principal back. Using the American Express platform, the advisor could buy individual securities himself, but Davis feels the specialized managers who run separate accounts have trading advantages. “I am buying in lots of $200,000, and they are buying $10 million, so they will get better prices,” he says.

Along with the ladders, Davis likes to diversify by holding some short-term bonds with maturities of two years or less. To do that, he uses mutual funds. These don't suffer much from rising rates, and the funds offer convenience and easy liquidity. For extra diversification, Davis likes distressed debt. For that, he uses a hedge fund vehicle because few mutual funds or separate accounts invest in the category. Distressed debt can produce healthy returns when the economy is strengthening and interest rates are climbing. During such a time, most bonds fall. But because default risk is declining, investors may bid up prices of distressed debt.

Rebalancing Act

For advisors using traditional platforms, it can be difficult to rebalance a portfolio that includes distressed debt and other varied choices. In some arrangements, the advisor must check each fund and separate account, manually figuring out when the portfolio needs adjusting.

Now the new integrated systems do the math automatically and notify advisors. “Our model can rebalance as needed,” says Chris Tomecek, president of Lockwood. “The system may rebalance every few months or once a week.”

The Smith Barney integrated system tells the advisor when rebalancing is necessary and makes calculations about where money should be shifted. The advisor gets approval from the client and then emails various fund and separate account managers, instructing them to liquidate or transfer funds. “It used to take me 45 minutes to rebalance a portfolio that had six separate accounts and funds,” says Norman Nabhan, a former financial consultant who is now national director of Smith Barney's consulting group. “Now we can rebalance in a few minutes.”

By saving time, the new integrated platforms make it possible for an advisor to service more clients. And the broad array of products offered by the system helps to attract more business, says Laura Van Zandt, director of mutual fund distribution research for Financial Research Corp.

“The new integrated products are the next leap forward,” she says. “Only a few companies have them, but everybody else is thinking about it.”

Separately Dominant

A list of leader firms in seperately managed accounts.
Firm Assets Under
Management (billions)
Smith Barney $163.2
Merrill Lynch 115.6
Morgan Stanley 40.2
UBS Financial 36.8
Prudential 25.6
Raymond James 12.5
Source: Cerulli Associates. Data through 4Q. 2003.
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