From the September 2003 issue of Investment Advisor • Subscribe!

September 1, 2003

Build Your Own

Tired of putting clients into cookie-cutter separate account programs? Here's how to build you own separate accounts, and how to decide if doing so is right for you

Five years from now, separate accounts will be as common as mutual funds in the arsenals of advisory firms serving affluent investors. Today, however, many firms are struggling to find a way to integrate separate accounts into their practices. If you haven't been satisfied with the separate account alternatives you've seen so far, read on. You may be closer to the answer--a customized answer, controlled by you--than you think. But before building that answer, let's define the question.

Just about everyone has seen the Cerulli research showing the phenomenal growth of separate accounts (see Figure 1.) The upward sweep of the Cerulli bar chart gives the impression that financial advisors have broadly embraced separate accounts. Nothing could be further from the truth.

Most of the growth so far has been limited to the wirehouses, which own 72% of the separate account market. Regional broker/dealers own another 17%. Independent advisors and advisors affiliated with independent broker/dealers represent only a little over 10% of the market. Banks and insurance companies each represent less than 1%.

Even in channels where separate accounts are most prevalent, the business is driven by a relatively small number of advisors. In the wirehouses, for example, estimates are that between 2% to 5% of the brokers drive 80% to 85% of the business. Schwab estimates that less than 20% of the advisors it works with use separate accounts in their practices.

It does appear, however, that things are beginning to change. Cerulli Associates asked advisors in six channels (banks, independent B/Ds, insurance companies, regional B/Ds, independent advisors, and wirehouses) which products they planned on using more of in the future. In every channel, except among independent advisors, separate accounts were listed among the top three products.

This research suggests that separate accounts are here to stay. They will become an increasingly important tool for serving high-net-worth investors and soon will be essential for any advisor who wishes to remain competitive. So why are most advisors still standing on the sidelines? And why do independent advisors, who so often lead the way in our industry, still appear reluctant to include separate accounts in their tool kits?

One reason for advisors' hesitance is that some are not comfortable with the alternatives they see for offering separate accounts to their clients. Most successful advisors have developed an investment process that they believe in strongly and an infrastructure to support that process. They do not want to abandon either the process or the infrastructure just to offer separate accounts. And in offering separate accounts, they do not want to pay an outside firm for services that they already provide.

Most separate account alternatives today are all-inclusive programs designed to give advisors everything they need to provide their clients with a comprehensive separate account offering. The program sponsor may be the advisor's broker/dealer or an outside firm like a turnkey asset management provider (TAMP). Either way, the sponsor offers a host of tools, products, and services through a sophisticated technology platform that enables the advisor to easily access the capabilities of the program. Program sponsors try to anticipate all the needs that an advisor could possibly have in offering separate accounts, and address them with a seamless bundle of solutions.

These programs are truly marvels of innovation, and for many advisors they provide the perfect vehicle for offering separate accounts to their clients. For others, however, these programs simply are not flexible enough to work well within the advisor's practice infrastructure. Alternately, the program may require the advisor to use and pay for services or capabilities they already offer. In the end, the advisor acknowledges the benefits of separate accounts, but does business without them because of the practical limitations of existing programs.

An Alternative Approach

Increasingly, advisory firms are exploring alternatives to the all-inclusive, bundled solutions that have ruled the separate account world to this point. With a little work, many have created alternatives that serve their needs better than the programs designed for a broader audience. In fact, for the right firm, a homegrown separate account solution can be far more cost-effective and provide a better client experience . So how do you decide if a homegrown solution is right for you?

There are four basic steps you should take before deciding whether to develop your own separate account solution. The first step is to identify all of the components you will need in order to offer a complete program. The second step is to determine those components you already have in-house and those that you will need to develop or outsource. Step three is to identify any additional staff you will need to run your own program. The final step is to compare the features and costs of your program with those of the solutions that are already available to you in the marketplace. In doing this final cost/benefit analysis, include the intangibles, such as your ability to control your own program (a positive) and the possible disruption to your practice (a negative).

Now let's go through each step in detail so you can see how it's done. Keep in mind as we walk through the process that a do-it-yourself solution is not for everyone. Yes, there can be significant benefits for the right firm, but getting there takes some work. Be honest with yourself about the level of commitment you are willing to make to the project. Focus on both the benefits and the ongoing effort that will be required.

Identifying the Components

This process is really quite easy, but seems difficult to some firms for two reasons. First, they get confused about the difference between process and product. Second, firms get confused about what is essential for a program and what would be nice to have. Let's clear the air on both counts.

Separate accounts are an investment product just like mutual funds, ETFs, and annuities. But they are usually offered through the "investment consulting process" (see Figure 2). This process is not unique to separate accounts and is used by many advisors today who build portfolios with mutual funds or other investment vehicles. However, to offer a competitive separate account program today, you need access to the separate account product and you must have the ability to offer that product through the investment consulting process.

In order to offer separate accounts using the investment consulting process, first you need to profile your client. This is often done through a questionnaire that collects information about the client's return objectives, risk tolerance, and investment experience. But a questionnaire is not essential. Some advisors develop a Statement of Investment Policy or work through a financial planning process to get the same information.

The next component of a program is the ability to develop an investment strategy for the client that takes into account the information gleaned during the profiling process. The strategy may be developed using an optimizer, a Monte Carlo simulator, or some other means. It may result in an asset allocation strategy using a "one-manager-per-style-box" approach or a "core-and-satellite" approach. It doesn't matter what methodology you use. What is essential is that you can develop an investment strategy based on client needs.

Next, you need a way to implement the strategy using separate account managers. This means gaining access to the managers as well as developing a way to determine which ones to select for your clients. Gaining access to the managers is becoming easier. But many firms have a problem determining how they will handle manager due diligence and selection. Fortunately, there are excellent outsourcing alternatives.

You also need to identify one or more custodians to hold the assets that your clients invest with the managers. Again, fortunately, there are an increasing number of alternatives available to advisors who want to develop their own programs.

The next program component is the ability to perform the necessary back-office functions. These functions are: (1) account opening and closing, (2) processing contributions and withdrawals, (3) portfolio accounting, (4) account reconciliation and (5) client billing. The separate account managers will take care of trading.

In addition, you will want to develop a procedure for monitoring and making adjustments to your clients' accounts. This involves ongoing monitoring of client accounts against their investment strategies and monitoring of the managers themselves. Most advisors feel comfortable monitoring a client's account against an established investment strategy and rebalancing or making other adjustments as necessary. Monitoring managers on an ongoing basis is another story. This is an area where outsourcing can offer solutions.

The final component is performance reporting. Performance reports come in all shapes and sizes. Opinions differ on what information should be included. There is no right answer when it comes to designing performance reports. If designed well, however, your performance report should do three things: promote interaction with your clients about their investments and other matters on which they seek your advice, help your clients stay the course during tough times, and help them decide when it is time to take action.

In-House or Outsource?

Now that we have identified the essential components of a program, the next step is to determine which of them you already have and which you will need to develop. For those components you need to develop, you must also decide whether to build them in-house or outsource them to a firm that already has the requisite experience and expertise.

Client Profiling. If you currently have a process in place today for profiling your clients, you should be able to use it in your own separate account program. In fact, it is a benefit to have a profiling process that is the same regardless of the investment products you use to implement the client's strategy. This type of "product-neutral" process is preferable to a "product-specific" process that requires a different profile for each investment product.

If you do not currently have a process for collecting information about your clients' goals, risk tolerance, time horizon, investing experience. and financial situation, you will need to put one in place. There are many sources for client profiling tools. Ibbotson has a software program that provides this capability. Advisor Software, a Lafayette, California-based software company, provides a solution that is more appropriate for larger shops because of its sophistication and cost. If software solutions are not for you, Deena Katz has written a book that includes templates for risk tolerance questionnaires (Deena Katz's Tools & Templates for Your Office, Bloomberg Press, 2001).

Developing Investment Strategies. Again, if you already have a process in place for developing investment strategies for your clients, you can probably use it with separate accounts. However, you may have to make some adjustments if you typically allocate assets to asset classes that are not well represented in the separate account universe. You can either eliminate these allocations or use mutual funds to fill in the gaps.

If you do not currently develop investment strategies or asset allocation recommendations for your clients, there are plenty of tools available that can help. For example, Ibbotson and Frontier Analytics have such tools; the tools also automate the process of creating proposals incorporating your investment strategy recommendations.

Accessing Managers and Custodial Services. It used to be relatively difficult for advisors to gain direct access to a suitable stable of separate account managers. Now it is very easy. Most of the major custodians either have, or are developing, separate account manager supermarkets. Schwab's is perhaps the oldest and best developed, but Fidelity and Bear Stearns are both making serious moves to serve advisors in this area.

Of course, any custodian that provides access to separate account managers can also custody the assets invested with those managers. Ask your current custodian or broker/dealer, and chances are they will be able to handle the job.

Screening and Selecting Managers. One of the major reasons why advisors are reluctant to enter the separate account area is that they do not feel comfortable doing due diligence on managers or selecting them. A few larger firms have developed the capability by hiring individuals with the requisite skills. But this is a costly solution and there are better alternatives emerging.

One is Prima Capital, a Denver-based firm that provides manager due diligence and research to advisory firms that offer separate accounts to their clients. Prima offers an extensive database of manager information, but also provides opinions and recommendations regarding the managers. And Prima has a Web-based delivery system that makes accessing their data and analysis very easy. In effect, Prima can act as your investment committee for separate accounts or as support for your internal staff.

Morningstar recently entered the separate account business, too, with an offering of its own. There are also a number of institutional manager databases, like Nelson's and Mobius's, but these tools are designed more for institutional investment consulting firms with experience in separate accounts. Several of these consulting firms make their services available in the high-net-worth marketplace, but this is a very costly solution.

Back-Office Services. If you already run your own portfolio accounting system, open and close accounts, process contributions and withdrawals, reconcile accounts and bill clients, you may already have the capabilities you need. There are some differences between handling mutual funds and separate accounts in the back office, but between your custodian and the firm that provides your portfolio accounting system, you probably already have access to the resources you need to work through these issues.

If your office does not currently provide these back-office functions for your clients, you will need to develop these capabilities. This means acquiring a portfolio accounting system and learning how to perform the necessary account administration functions. For a firm that has never done this before, this can be a daunting task. For firms of significant size, there are back-office outsourcing solutions offered by firms such as Mellon, State Street, Rorer Asset Management, and ABN AMRO.

The first step in building your own back office is to identify a portfolio accounting system that is right for your firm. For most financial advisors, the systems offered by Advent or Centerpiece would be the place to start. For larger, more industrial-strength applications, Checkfree's APL or Integrated Decision Systems' GIM2000 system might be more appropriate.

Next you must learn how to handle the paperwork and assets that will flow through your back office. This means developing processes and procedures that can be integrated with those already in place in your office. The best approach is to hire staff with back-office experience and have them lead the way. If that isn't feasible, look to your custodian and your portfolio accounting system provider to train your current staff.

Account Monitoring. If you currently have tools and/or procedures in place that help you monitor client portfolios on an ongoing basis, they will probably be useful in monitoring separate accounts as well. Make sure that your tools and procedures allow you to monitor portfolios relative to their stated asset allocation strategies and that you have some way of measuring the risk associated with each portfolio. You will also want to be able to monitor the individual managers you are using.

If you don't have these capabilities, once again, there are many alternatives to help you with the process. There are a number of firms that provide systems to help you monitor what is happening with your clients' portfolios across a number of dimensions, including LifeHarbor, Tamarac, RiskMetrics, and Smartleaf. Firms like Prima and Morningstar can help you monitor managers on an ongoing basis. And many broker/dealers and custodians provide account look-up capabilities via the Web.

Performance Reporting. If you already produce performance reports for your clients, chances are good that your current system will handle separate accounts, too. If you do not currently produce performance reports, you can use the performance reporting capabilities of your portfolio accounting system, or turn to one of the outsourcing solutions available, such as Memphis-based Investment Scorecard.

Determining Staffing Needs

The number of people you will need to hire to staff a program and the cost of those people can vary dramatically from firm to firm. The most significant variables are: the qualifications and capacity of the staff you already have, the volume of new separate account business you expect to generate, how you resolve the various "build versus outsource" choices you have, and the cost and supply of labor in your geographic area.

In the best of circumstances, you will not need any additional staff. If you already use the investment consulting process, run your own back-office, and produce performance reports for your clients, you may already have the staff you need. You may not have the internal expertise to handle manager due diligence and selection, but there are good outsourcing alternatives to cover that area.

What if you don't have the pieces in place already? Well, let's assume you will be primarily involved in client acquisition and relationship development. You can probably incorporate separate account capabilities into your practice with the addition of two people to your staff. The first would be an investment-oriented person who would handle investment strategy development, portfolio construction, proposal generation, and account monitoring. This person would also work with you to lay the foundation for implementation of the investment consulting process in your office.

The second person would focus on operations and account administration, handling all back-office functions and generating client performance reports. He or she would also be responsible for day-to-day interaction with your custodian and for dealing with administrative requests from clients.

If you are truly starting from scratch, consider hiring a consultant familiar with the relevant tools and technology to help you get started. Together you can sort through the alternatives, saving time and avoiding mistakes in the process. Consultants can be particularly useful in the areas of technology selection and integration.

Comparing Features and Costs

Now it's time to compare what you can build yourself with the programs already available to you. You should make the comparison in two dimensions: program features and cost.

First, let's talk about program features. Compare the look, feel, and quality of each component of your separate account capability with that of the programs currently available to you. Chances are you will find that your program will not match up well in certain areas, but may be more to your liking in others. Remember, the programs you are comparing to your solution have been developed over many years and with millions of dollars of funding. The question is not whether your solution is better. Rather, it is whether it provides a solid separate account capability that integrates well into your practice and costs you and your clients less than the alternatives.

Now let's turn to comparing the costs. When you use an outside program like a TAMP, there are four components to the fee your client pays: your fee; the manager's fee; custodial and trading expenses, and the program sponsor's fee. These fees may not be broken out so you can see them, but make no mistake: Your client is paying them.

If you develop your own program, you will still want to be paid, the manager will still want to be paid, and so will your broker/custodian. The savings, if any, will come primarily from cutting out the program sponsor's fee, which these days typically range between 25 and 50 basis points. For purposes of our example, we will use a figure of 40 bps.

Now let's look at the easiest case first. Assume your firm already has all the tools, technology, and staff it needs to offer separate accounts, with the exception of a source for manager due diligence and selection information. Depending on the level of service required, a moderate-sized financial advisory firm could acquire that information for between $5,000 and $10,000 a year from Prima Capital, for example. A firm with only $3 million in client assets invested through our hypothetical TAMP would generates $12,000 in sponsor fees. So the direct cost of the homegrown program would be less. Of course, running the homegrown program takes work and creates distractions that are not reflected in the direct costs. The TAMP program may also have some intangible advantages over the homegrown alternative. But let's say your firm already has $25 million invested through the TAMP. Your clients are paying $100,000 in sponsor fees. Your homegrown solution will generate a direct cost savings of $90,000. If you and your clients split and pocketed the savings, would the intangible benefits of using the TAMP program seem as important?

The harder case is an advisory firm that truly has to build its separate account capability from scratch. A reasonable estimate for the annual cost of the tools and technology to build such a program might be in the $35,000 to $150,000 range, depending on the elegance of the solution. And a reasonable estimate of the fully loaded annual cost of hiring two individuals to support the program might be $150,000 to $200,000. So the total cost of a complete from-the-ground-up project could range anywhere from $185,000 to $350,000. A firm undertaking this type of project would need to have somewhere between $47 million and $88 million under management at the hypothetical TAMP to generate enough sponsor fees to make such a project even worth considering. And that does not take into account the intangible costs and distractions such a firm would incur.

Obviously, there are many variables to consider in deciding whether to develop your own separate account capabilities. Figure 3 may help you organize the process of deciding whether developing your own separate account capability makes sense for your firm. Keep in mind that, in the years to come, all truly competitive financial advisory firms will offer separate accounts. If you haven't done so already, now is the time to figure out how you will incorporate them into your practice.

Reprints Discuss this story
This is where the comments go.