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Taming the SMA Hydra

To what can administering to a separately managed account be best compared? Arm-wrestling an octopus, some posit. Herding cats, others offer. Fact is, just about any advisor offering managed accounts can testify to the complexity of the related administration and reporting. If a client has six managers in an account, each manager requires a separate pipeline, or for trading and activity, and the advisor

To what can administering to a separately managed account be best compared? “Arm-wrestling an octopus,” some posit. “Herding cats,” others offer.

Fact is, just about any advisor offering managed accounts can testify to the complexity of the related administration and reporting. If a client has six managers in an account, each manager requires a separate pipeline, or “sleeve,” for trading and activity, and the advisor must somehow coordinate all these accounts into one portfolio. Fortunately, advisors are awakening to a remedy for these administrative challenges: overlay portfolio management (OPM).

Not so long ago, it was the rare advisor who had an even rudimentary understanding of separately managed accounts. SMAs were the almost exclusive domain of high-net-worth individuals and family offices. Today, of course, managed accounts have become more commonplace, thanks in part to their continued evolution and to lower account minimums.

As traditional SMAs became more popular, multidiscipline accounts were created by combining separately managed accounts into one brokerage account. They offered some benefits, but firms and managers soon realized that the process could be taken one step further by including other asset types in managed accounts. By including products such as mutual funds, annuities and exchange-traded funds in a managed account, the unified managed account (UMA) was created. And although this shift helped separate account products mature and grow, the advance did little to address the technology and administration issues involved in their management.

Understanding OPM

Overlay management is the next evolutionary step in separate accounts. It uses analytical and monitoring tools to make discretionary investment decisions on a daily basis. OPM not only handles most of the administrative tasks involved in managed accounts, but also allows for a variety of customization. Simply put, the overlay manager coordinates activity between the advisor and the multiple managers involved.

It represents a significant change in the way money managers work by providing model portfolios rather than focusing on both transactions and stock selections.

With OPM, individual money managers provide the models for investing, and the overlay manager uses these models to make investments on behalf of the client. In other words, overlay managers are taking on the responsibility of making investments from money mangers, while also handling things such as customization and rebalancing issues that have traditionally been addressed by the advisor.

The process separates such decisions into two categories: model portfolio decisions and client-specific decisions. Model decisions are actions made to all accounts, such as stock selection, while client-specific decisions are actions made to only one account because of a particular client request or circumstance. For example, if a money manager decides to replace holdings of auto manufacturer Ford with GM, the overlay manager would make this replacement for all accounts involved. Yet if the action would cause a particular account to incur an expensive short-term capital gain, the overlay manager would then alter the decision for that account.

It's this decision-making process that allows clients to see the most benefit from overlay management. Because model portfolios can be customized, a variety of benefits are available, including ongoing tax management, risk management and automated rebalancing.

In the past, tax management has meant selling shares in December for some tax-loss harvesting, then forgetting about tax implications for another 12 months. With overlay management, tax harvesting occurs on a transaction-by-transaction basis.

Two of the most popular providers of overlay management services are Placemark Investments and Parametric Portfolio Associates.

Placemark's product is called Total Overlay Portfolio Management Services. According to research conducted by Matt Schott at Boston-based TowerGroup, the Total Investment Platform carries 41 money management firms with over 62 separate account products.

Parametric's product is called Integrated Separate Account Management system. Its users include SEI Investments, which was Parametric's first customer and has since become the company's largest client with somewhere in the realm of $1 billion in investments running on the system.

“We're finding that as OPM is becoming more fleshed out in the marketplace, the number of conversations we're having with sponsor firms is also increasing,” said Brian Langstraat., CEO of Parametric.

Active Management Vs. Passive Management

As overlay management continues to grow in popularity, there is a divide between the ways these unified portfolios are managed.

“Overlay management is on a continuum from what's called passive overlay to active overlay,” explained Langstraat. “Passive overlay is just taking in the manager's models and putting them together like a trade-order routing system, where you simply pass them through to the market.”

This style does not utilize the full advantages of customization for portfolios, but simply combines trades into one account and reconciles them.

“What we call passive overlay is really an administrative process,” says Randy Bullard, president of Placemark Investments. “You might have five managers, and with passive overlay, they're now trading into one account, but you're still not able to implement features of the product that require coordination among those five managers.” This is particularly true of tax advantages, Bullard says, since they are measured at the client level, rather than at the manager level.

Active overlay management, by contrast, is just what its name suggests. Overlay managers step in and address issues for clients while taking into account their risk boundaries. These managers keep a keen eye out for things such as wash-sale violations and loss harvesting.

“You're underselling the whole process if you're not using active management,” says Bob Burns, director of the managed assets group for McDonald Financial Group. The Cleveland-based regional broker/dealer has over 700 advisors with the ability to implement its managed-money programs, and McDonald implemented a unified managed account program in October 2002, using Placemark for overlay management. After just 18 months, the firm has over $205 million in new SMA assets thanks to this area.

“I don't think we're at the point where a system will be able to make decisions for you,” he said. “Remember the boom in online trading a few years ago? We've already learned that more information does not mean easier decisions.”

Benefits for Advisors

OPM sounds like a great concept on paper, but will it really help advisors improve their business, or is it simply a glorified version of an existing product? As with managed accounts themselves, the answer to that question is evolving.

Right now, many advisors are personally handling the functions overlay managers provide. Outsourcing these services could free up more time for the advisor to manage what matters most — client relationships.

“In this role, the advisor would communicate changes initiated by the investor, the money manager or the overlay manager,” Schott says. “However, the overlay manager would be responsible for all day-to-day decision-making and administration of the portfolio across all the sleeves.”

He adds, “This model will particularly hold sway among small and midsize brokerage firms, and most of the independent advisor market.”

Some advisors are taking a wait-and-see approach to outsourcing these services with an eye towards measuring how overlay managers perform over time.

“Advisors who have been longtime participants in managed accounts will want to see how effectively overlay managers replicate or beat money managers' performance,” says Schott. “The inability of the overlay manager and sponsor to recruit an advisor's favored managers is also hindering adoption by some advisors.”

Another hindrance: Some advisors wonder whether outsourcing managed-account functions marginalizes the advisor in the eyes of the client.

Because of these concerns, Schott insists that overlay managers must do a better job of explaining the overlay process and addressing these concerns in order for the field to grow.

The Future of OPM

Burns believes OPM will lead to a consolidation of the industry.

“I think we'll see the combination of smaller platforms, where everything will be in one managed account,” he says. “Things like mutual fund wraps and traditional SMAs will give way to the overlay management platform.”

Langstraat adds: “The reporting of these accounts is still in its infancy, and it's going to be important going forward. For example, if manager A decides to sell a stock, but an overlay manager doesn't sell all of it because it's a short-term gain in a particular portfolio, that's not manager A's decision. So the overlay manager needs a second sleeve that takes these things in account for reporting purposes.”

OPM might also bring about a shift in the asset types included in these accounts.

“You'll see continued evolution in terms of the products offered through overlay management,” says Bullard. “Things like niche asset-class products, such as option strategies and managed futures — there are all kinds of things that could eventually be offered as a sleeve in a managed account using overlay management.”

Reason to Be

The four major functions of overlay managers.


Overlay managers coordinate trades among accounts within a portfolio. If one manager sells a particular company, while another purchases that same stock, the action might lead to a wash-sale. Overlay managers keep a close eye on such transactions.

Tax-lot management

Overlay managers keep track of clients' tax information and are able to address tax issues as transactions occur. For example, they may defer a sale that leads to a short-term gain until the transaction creates a long-term gain.


Because overlay managers are making consistent changes to accounts, they are able to rebalance asset classes, cash flow and types of investments as soon as a transaction overweighs an area.

Risk management

Because of their regular involvement in a client's portfolio, overlay managers are able to keep a careful eye on risk. This decision-making process is similar in nature to the attention paid to rebalancing and tax issues.

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