The Mutual Fund Killer?

Traditional separate account programs can come with a variety of frustrations. Advisors must scan through a menu of dozens of managers, trying to pick a few that will complement each other and, together, achieve the client's goal. Even with careful research, advisors often wind up with redundant positions. Remember a few years ago when all kinds of managers were piling into the same fast-rising stocks? It was not uncommon for a broker with six different managers to wind up with Cisco Systems and Microsoft in all of them.

It's easy to see why that doesn't work so well in this market. So, to make sure that managers work in harmony — and not by singing the exact same notes — more advisors are turning to multiple discipline products (MDPs). With an MDP, an investor can open a single account that includes several managers and coordinates all their activities. Instead of selecting several growth and value managers, a client chooses one MDP account that covers all the bases.

Salomon Smith Barney gets credit for developing MDPs three years ago. Last year, the broker attracted $250 million in new assets to its MDP program, according to Financial Research Corp. Other companies are rushing to catch up. In the past year, new programs have been started by UBS Global Asset Management, Brinker Capital, Affiliated Managers Group and ADVISORport.

Total assets in the new programs are still small, says Financial Research, but FRC predicts that within five years MDP accounts will hold $250 billion.

“These provide a new level of money management sophistication to clients who haven't had access to it before,” says Steve Coggins, a partner with Jones Coggins & Co., a registered investment advisor in Wilmington, N.C.

Because they are broadly diversified, MDPs tend to produce relatively stable results, and the accounts are simple, issuing only one statement. Eventually, the multiple accounts may give brokers the flexibility to mix and match advisors. But for the time being, most programs provide standardized portfolios with off-the-rack asset allocations. Some advisors complain that the standardized approach limits their ability to customize portfolios for clients. In the process, advisors lose their role as asset allocators. However, many advisors praise the new accounts, saying that they provide specialized asset allocation assistance.

“I don't want to spend my days monitoring the daily trading activity of a dozen managers,” says Lou Meyer, president of Boardroom Advisory Group, an RIA in Cincinnati. “The multiple discipline product frees me to spend more time with my clients, developing overall plans, doing what I do best. ”

New technology has enabled the development of MDPs and helped them overcome some of the handicaps of traditional separate accounts. For starters, the diversified accounts have investment minimums of only $100,000. Traditional separate accounts require minimum investments of at least $150,000, and building a diversified portfolio takes considerably more money. Say a traditional separate account investor seeks to own a mix of large, small and international stocks. He would likely have to open three accounts and invest with three managers, putting $150,000 in each category. With a multiple discipline account, the investor could put $100,000 into a single diversified portfolio that would include three managers in different asset categories.

Why are money managers willing to accept smaller minimum investments in MDPs? To appreciate how the efficiencies are achieved, consider that the assets of traditional separate accounts must be held by a bank or other custodian that typically charges about $500 for each account. That cost alone amounts to a charge of 50 basis points on a $100,000 account. In addition, money managers for traditional accounts may buy and sell stocks for each client. When all the transaction charges and other expenses are added, small accounts are simply too expensive.

The company operating an MDP cuts costs by consolidating portfolios. Say the client invests $100,000 in a diversified portfolio that includes three money managers. In some state-of-the-art systems, the three managers don't buy individual stocks. Instead, they produce a model of stock picks. These picks go to someone called an overlay manager who coordinates the MDP and actually buys and sells the stocks. The overlay manager need only open one account for the client, not three. Because the money managers don't have to execute transactions or handle individual accounts, they can cut the cost of their services and serve smaller accounts.

The overlay managers can do more than cut costs. They serve as monitors, coordinating the efforts of the different money managers in the portfolio. With traditional separate accounts, managers sometimes work at cross-purposes. One money manager may be buying a stock at the same time that another is selling. When the transactions are completed, the client faces a tax bill for a sale that did not accomplish any investment goal.

To avoid such inefficiency, ADVISORport, which markets MDPs, employs overlay managers who check to make sure that two money managers have not chosen the same stock. When there is duplication, the overlay manager can eliminate a stock pick or reduce its weighting to ensure that the client receives proper diversification. In addition, the overlay manager monitors tax efficiency.

If one of the money manager's models calls for selling a stock and taking a short-term capital gain, the overlay manager can hold the stock longer until the client qualifies for a long-term gain, which comes with a lower tax bill. “This is a powerful tool that advisors can use to reduce tax bills and better serve clients,” says Gregory Horn, ADVISORport chairman.

The MDP programs have been evolving quickly. When Smith Barney began its program, it offered standardized packages using in-house money managers. An advisor with a conservative client could pick an off-the-shelf portfolio run by Smith Barney managers that would include bonds and blue-chip stocks. Since then, the firm has recruited outside managers, such as Strong and Putnam. “We want our advisors to have access to the best managers whether they are in-house or from the outside,” says Frank Campanale, president of Salomon Smith Barney Consulting Group.

Most Smith Barney advisors in the MDP program still rely on standardized packages set by the company. But as the program evolves, advisors are gaining more freedom to determine asset allocations for clients. The eventual goal is for advisors to build completely customized portfolios. When the system is complete, an advisor would be free to put, say, 12 percent of a client's assets in small-cap value stocks — or nothing at all.

Brinker Capital, a longtime marketer of separate accounts to brokerage firms, recently began offering a multiple discipline product that relies on 40 outside managers, including Stein Roe, State Street and Fred Alger. In a typical arrangement, a broker uses a questionnaire to determine the client's goals and risk tolerance. Then Brinker designs a portfolio and selects managers. Brinker can accommodate clients who wish to exclude alcohol or tobacco stocks. And if an investor already has a big position in a single stock, that issue can be eliminated from the managed portfolio. Contracts with brokers vary. Some must accept the portfolio designed by Brinker, while others are entitled to set asset allocations themselves.

Financial advisors report that clients switching to MDPs include a mix of people who used to rely on mutual funds or individual stocks. Brokers making the transition from transaction-oriented practices to fee-based systems have also been eager supporters of the new accounts. To be sure, mutual funds are not likely to go away. But MDPs stand to provide increasing competition. “As the accounts improve and add more features, you will see more financial advisors looking to use them,” predicts Nate Dalton, Affiliated Managers executive vice president.