From the May 2005 issue of Investment Advisor • Subscribe!

May 1, 2005

A Proper Fit

Here's what happens within a separately managed account, and how to make sure managers follow your client's needs

Separate accounts are a useful tool in managing client assets, but they have been oversold by many firms. It's important to know exactly what a separate account is, what happens behind the scenes, and who should--and shouldn't--use separate accounts.

A separate account is a brokerage account titled in the name of the client. The client directly owns the individual securities held in the account. Clients will sign a limited power of attorney that allows the investment manager to buy and sell securities in their account on their behalf. It does not allow them to transfer money out of the account or commingle their clients' assets with other accounts. The domicile firm will deduct fees for both the manager and itself directly out of the account unless instructed otherwise.

Because it's your client's account, the client will receive confirmations in the mail for every trade. If your manager owns a lot of securities or has high turnover, clients will receive a lot of confirmations in the mail. A major benefit of separate accounts for clients is knowing in "almost-real time" what is happening in their accounts, compared to owning the average mutual fund, which will typically disclose its holdings only on an annual or semiannual basis.

Everyone knows that some investment management firms manage hundreds of thousands of separate accounts. However, every account doesn't receive individual attention from the portfolio manager. Each account is matched to a model, and variances are eliminated by buying or selling securities for blocks of accounts with similar variances. Portfolio managers are usually focused on security selection and the performance of the product as a whole. The investment professional at a money management firm who has the most direct contact with an individual account is a trader.

The Trader's Role

The trader's job is usually twofold: to get the best execution for each trade, and to minimize dispersion. Best execution refers to a trade or series of trades that optimizes the trader's objective, which is not always solely to obtain a best price. Since a trader or traders at the same firm will often execute trades in the same security for multiple products, minimizing market impact is also important. Some firms focus on the time element as well--the timing cost relates to potential returns lost due to slow trade implementation.

For example, a portfolio manager might want to buy ABCD, a moderately liquid mid-cap OTC stock, into a number of the products he is responsible for. The first step is to inform the trading desk at his firm. In the best of all possible worlds, share counts are generated for every account, including any mutual funds, and then blocked together to form a single order. This order is worked by the trading desk. In the event that the entire position could not be purchased, it is typical for the shares bought to be prorated across all accounts. Whether or not the entire order is filled, every account receives the same price for its portion of the order.

Often, orders must be directed to certain firms for certain accounts. This occurs at either the client's discretion or because the domicile firm requires all trades be done through its own trading desk. For this reason, multiple orders need to be created--one for each separate firm which has directed brokerage, and then the aggregated block that represents the remaining accounts that have no restrictions. Unless otherwise disclosed in the manager's Form ADV, it is usual for the order of these trades to be randomly determined and then executed. Each block of accounts receives a different price. It is not always an advantage to be the first to buy or sell, especially with extremely liquid securities. The differences in purchase price create dispersion among the different groups of accounts.

There is no benefit to deliberately directing brokerage in order to be placed in a different group, or to be given your own spot in the random rotation. Most often the large block receives the best execution because it is usually "worked" by the trading desk. By "working" an order, the desk is giving the trade its full attention and the benefits of its skill. If a small account is directed, then it is usually routed to the relevant exchange to be executed at the market.

Traders also seek to reduce dispersion among like accounts. "Dispersion" refers to the variance in return among accounts in the same investment style. All accounts of a single style are aggregated together to calculate a composite return for a specified period of time (usually quarterly and annual performance). Certain accounts can be excluded from the composite due to large cash flows, inception date, or client-directed restrictions. Few accounts will achieve the exact return of the composite, but usually most are very close. Dispersion measures the grouping of returns around the composite return. "High" dispersion refers to the fact that several accounts have returns that are materially different from the composite return.

Dispersion can be caused by many different events, including directed brokerage, the client requesting tax selling or account restrictions, time of opening, or time of cash flows into or out of an account. From the client's perspective, dispersion is not necessarily bad--in theory, the account is just as likely to outperform the composite as to underperform it.

Managers want to minimize dispersion for a variety of reasons, primarily because it eliminates the question "Why did account A do better than account B?" Managers would prefer to avoid being asked this question, whether by the client, the financial consultant, or by the SEC's auditors. Each brokerage firm has teams of people who evaluate managers, and one of the criteria is dispersion. If dispersion is high, then a manager might not be able to establish new relationships with other brokerage firms, or may lose business at a current brokerage firm client.

The Portfolio Manager

The portfolio manager's job is to generate the best possible performance (within the product's mandate, and for the given level of risk) for the product, and create the model that is used by the trader to implement the portfolio manager's investment decisions. Unless your client's account is several million dollars or more, it will likely not be handled directly by the portfolio manager.

Account restrictions can be a blessing and a curse. By restricting certain securities and preventing the portfolio manager from buying them if they are included in his or her model, you can be certain you are creating account dispersion--your client's account with restrictions will probably have materially different returns from other similar accounts. You may have better or worse performance, but it will be different over the course that the restricted securities are held in the composite accounts.

However, restrictions can be a valuable option for some investors. If you want access to a certain manager or a certain investment management firm, but are wary because their typical holdings might cause issues within your client's broader portfolio or for other reasons, then a separately managed account may offer the only real alternative to investing via a mutual fund. There are many reasons why you may want to have restrictions on your client's account:

  • Your client already owns a lot of stock XYZ, because the client or client's spouse works for the company, and they don't want to own any more.
  • Your client inherited stock which she doesn't want to sell for sentimental reasons, but that she doesn't need to own anymore. Your client has strong convictions about certain industries such as tobacco or alcohol.
  • One of your other managers has a large exposure to a certain stock, and they have no plans to sell it in the foreseeable future.
  • These are all legitimate reasons to use a restricted account. There are caveats, however. As a professional hired to oversee your clients' assets, you want them to have as few limitations as possible.

Don't Do It for the Prestige

Some people, clients and advisors, are attracted to the perceived "prestige" of separate accounts. This is not a good reason to open a separate account. The fee structure for a managed account is less favorable to the client unless he is receiving ancillary benefits such as tax management or use of restrictions. These are powerful tools in managing a complete portfolio, and their availability can be well worth the extra fees associated with these accounts.

Most managers are very good at implementing client directions, particularly when they are very explicit. If you want to place a restriction on an account, be sure to send the instructions in writing via e-mail, postal mail, or fax, and follow up to be sure it was received.

Once an account becomes different from the composite, it can take a long, long time (or many small transactions) to bring it back to a close match. If your manager uses 50 securities, then each of those securities performs differently over any time period--which changes the mix of securities as a percent of assets. This is why changing just one security can create meaningful dispersion in a managed account.

There is a good approach to managing clients' taxes, and a bad approach. The bad approach is to pick up the phone on the afternoon of December 31st, and hear your client say, "Take losses!" Most managers cannot even guarantee this will get accomplished if they are informed in the 11th hour, although they will certainly try. The best approach is to follow your client's tax situation throughout the year, and guide the client periodically. Again, it is best to be very explicit. Many managers have forms that can be faxed to clients to walk them through the exact information the manager finds important.

Separate accounts can be a powerful tool if used correctly, and if expectations are set appropriately. By understanding how separate accounts work operationally, it is easier to determine which clients can benefit most from their advantages.

I happen to manage money through a mutual fund and separate accounts. But regardless of the vehicle you choose, you should always make sure it matches your client's needs, and can adjust to those needs as they change over time. Separate accounts are perfect for some clients, and entirely inappropriate for others--the same goes for mutual funds.

Alex Motola, CFA, is directly responsible for the Thornburg Core Growth Fund (THCGX). He is a portfolio manager and a managing director at Thornburg Investment Management in Santa Fe, and can be reached at

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