From the January 2007 issue of Wealth Manager Web • Subscribe!

January 1, 2007

Separate No More

Separately managed accounts aren't as separate as they used to be. Increasingly, these products are being paired with other investments as customers seek better performance and increased advisor input.

Interest in stand-alone SMAs is being challenged as dual platform or unified managed account (UMA) environments become more enticing, observes Steve Gresham, executive vice president at Phoenix Investment Partners, a money management firm with headquarters in New York City and Hartford, Conn. "Dual platform in this instance means holding both a managed account solution and a brokerage account with ? la carte investments," Gresham notes.

Given six years of flat equity performance in a generally bullish market era, the one-stop-shop "solution-in-a-box" that was once the SMA's calling card no longer cuts it for many investors, observes Gresham, who is also a consultant to the wealth management business and author of The Managed Account Handbook.

Baby boomers are particularly ripe for change. These newcomers to the SMA space have been "bored to death," quarter after quarter, says Gresham, and are finally wondering if they've come to the right place by investing in managed accounts that were created in a bullish market era.

The boomers' experience is not one of high-flying markets like their parents,' but of volatility, he explains. To sit still in a long-term SMA arrangement makes no sense to the restless boomer population. "The boomer client comes along and wonders why he can't have various investments in one account. They think it's stupid--and it is."

The solution? Clients are driving top advisors to purchase opportunistic investments such as ETFs and hedge funds to accompany straight SMA pieces.

Mutual funds are also being paired with SMAs as part of new UMA strategies. "Before, you had individual pieces that had no investment policy pulling them together," Gresham explains. "That morphed into the managed solution which has now morphed into managed funds with more opportunistic pieces added on." These might include not only alternative investments, "but also traditional, bottom-up managers."

At a time when the industry is working to create and implement new standards to simplify communications between SMA sponsors and money managers and eliminate the hodgepodge of account applications and account maintenance standards that currently exists [See sidebar, page 36], experts say the maturing SMA space will benefit from flexibility, as well as uniformity.

Time to get real

Boston-based Cerulli Associates reported that as of the third quarter of 2006, separately managed account assets reached $745 billion--up from $658 billion a year earlier. (Cerulli also includes some UMA products in its calculation.) Cerulli senior analyst Jeff Strange says the time has come to turn theory into practice. The next step in the advancement of managed accounts is to create an environment in which advice and financial planning are not held back by a product-focused perspective that limits access to appropriate investment vehicles, Strange maintains.

His July 2006 report, "The State of Managed Accounts, Next-Generation Advice Delivery," says that mutual fund advisory programs were the forerunners of the new, "vehicle-neutral" unified managed account platforms that have been making such a splash in the separately managed account arena. UMAs are still in their infancy and represent a very small share of total managed account asset volumes, but they are already a significant part of new business coming through the door for SMA provider ADVISORport, of Valley Forge, Pa., which has been offering a UMA platform since early 2005. Although UMAs represent only about 5 percent of ADVISORport's business right now, says company president Steve DeAngelis, these new vehicles account for about a quarter of all new SMA assets stemming from ADVISORport's traditional separate account sources.

Whereas SMA experts continue the debate over how UMAs are meant to work, "To us it is where a client or an advisor will mix together investment models from third-party money managers with mutual funds or ETFs, all into a single client account with a very specific targeted allocation to each of those," DeAngelis says.

Quality time with advisors

Cerulli approves. "A significant component to developing better advice is creating an environment in which solutions are not handicapped by having to work exclusively with certain investment vehicles," Strange observes in his report. "Hence, the vehicle-neutral, or UMA, platform has become a benchmark in the development of next-generation advice offerings."

"We believe that UMAs offer a better advice delivery model because they allow for more creative, flexible portfolio construction options by allowing multiple vehicles, and they also create a more efficient and streamlined way of delivering investment management to the client, which allows the advisor to spend less time on picking investments and handling administrative tasks and more time advising the client," Strange added in an interview with Wealth Manager.

Cerulli has been tracking UMA development since the first quarter of 2006 and, as of last November, was collecting data from a total of nine SMA sponsors with UMA assets totaling $24.1 billion. From largest to smallest, the respondents were Wachovia, Morgan Stanley, Lockwood Financial, RBC Dain Rauscher, Standard & Poor's, LPL Financial Services, Morgan Keegan, 1st Global and Brinker Capital. [See "Rise of the UMA," page 39]

Why the UMA? The answer, apparently, comes down to being a better advice delivery model. At least that was the single most compelling reason for developing a UMA cited by sponsors responding to the Cerulli survey. "Through better advice, it is expected that better sales should follow, even if not in a business model that is necessarily more profitable than existing programs," Strange explains.

UMAs: Enough advisor input?

Cerulli segments UMA environments into three models, determined by the varying packaging discretion at the home office level as opposed to the advisor level. Cerulli originally applied a similar framework to the mutual fund advisory market, classifying programs by the degree of flexibility advisors were permitted. Strange believes that UMAs will follow the same path as mutual fund advisory programs, which started out heavily packaged, with little or no advisor input, but developed into strategies that leveraged advisor expertise.

"Of all the three types of UMA s, Model 1 (packaged) will present the most disintermediation from the advisor and investor for the asset managers," says Strange's Cerulli report. Because advisors lack input on manager selection in the portfolio construction process, it limits the amount of influence managers can have on the usage of their products, Strange explains. "The Model 2 (hybrid) arrangement will fulfill the desire of many advisors to have input over the investment management aspect for their client accounts, while still heavily leveraging the managed account group and the UMA platform."

Eventually, however, Strange believes that many sponsors will strive toward developing Model 3, (open) UMA capability, to cater to special advisor situations or as a place to park investments that are not on their platform. "Morgan Stanley began with locked UMA models," Strange says, but "now offers an open situation where advisors are doing asset allocation and picking managers for the different sleeves."

Of the nine strategies Cerulli is tracking, most are still packaged or hybrid programs, Strange reports. "Going forward, I think we'll see open and hybrid programs growing a lot, and we think this will advance advisor education," he concludes.

Last fall, ADVISORport's DeAngelis reported that his company's UMA approach was packaged with "not so much input from advisors." However, "We do have over 40 of these products to choose from, which covers most scenarios," he says. Moreover, sometime this year ADVISORport plans to launch its next UMA models, which will allow more advisor input into the construction.

DeAngelis notes also that about half of the UMA accounts coming his way are opting for ADVISORport's tax-managed UMA. "For many [clients] the tax considerations are a significant portion of the managed account world," he says. "To us it was very important to offer that in a UMA."

Other ways to skin the cat

While UMAs may well be the strategy du jour, advisors hardly need a UMA to offer clients an SMA strategy with an extra something on the side.

Stephen F. Lovell, CFP, CLU, CFS and an advisor with Forsyth Heritage based in Walnut Creek, Calif., says he deals mainly with people 55 and over who welcome his help in assembling guaranteed investments to preserve the wealth they've created. This gives them extra freedom with the rest of their money, says Lovell, who recommends some level of SMA exposure to nearly every one of his clients.

"A lot of studies say combining guaranteed investments with non-guaranteed investments allows you to be aggressive elsewhere to increase the probability of having a sustainable withdrawal rate that doesn't deplete your assets before you die," Lovell observes. Thus, he will often allocate 20 percent to 40 percent of a client's assets into annuity products providing "living benefits." The rest goes into an SMA.

Lovell made a presentation to 83 CFPs last Fall, discussing the utility of such products, which have been offered as retirement planning tools for the past decade by major insurance companies including Jackson National, the Hartford, John Hancock, MetLife, and ING. The short story is that, for a fee of 45 to 75 basis points, advisors can guarantee no loss of principal due to market underperformance. Should the value of the account increase above the original principal amount, "that higher value becomes your new floor," he says.

Clients can also arrange to have a certain percentage of their total investment amount guaranteed as income over the course of their lifetime--say, 5 percent of their investment for life. There are limits, of course: "One client I have put $500,000 into it and rather than receiving 5 percent [of that sum every year] for life--since $25,000 a year was insufficient in his case--chose an alternative providing 7 percent for 14.2 years."

According to Lovell, the SMA's tax management features--particularly "the fact that they let you choose when to pay your taxes"--continue to serve as a major draw. Moreover, "It is easier now in this generation to get a well allocated portfolio rather than one investment style or strategy," he observes.

Account features such as tax management overlays and attractiveness to advisors seeking money managers' research and due diligence have helped the SMA business to thrive despite the widely held perception that these instruments are just too expensive given their performance.

Meanwhile, banks are getting more aggressive. MMI reported that wirehouses Citi Global Wealth Management, Merrill Lynch, Morgan Stanley, UBS Financial Services, and Wachovia Securities controlled 79 percent of the industry's assets at the end of 2Q06, and that these large wirehouses remained the dominant distributors of separately managed accounts. Banks, currently controlling 7.8 percent of industry assets, were expected to increase their share, however, as more programs come online and bank marketing efforts mature.

Performance quandary

Many advisors continue to bemoan the state of the SMA marketplace and complain about hefty fees and inadequate returns.

Last fall, CFP and ChFC Eric Hess spent several hours contemplating the shortcomings of separately managed accounts with dozens of wealth managers attending Schwab's "Impact 2006" conference in Washington, D.C. "The overwhelming consensus was that the returns, net of fees and taxes, are far below strategically managed mutual fund portfolios," says Hess.

"SMAs are for non-traditional marketers and poorly informed investors and advisors--both institutional and high net worth," complains Hess, who manages more than $50 million in assets at his McLean, Va.-based firm, Alpha Financial Advisors LLC, and views separately managed accounts as a well marketed but ineffective solution for wealthy investors that like the cachet of SMAs but don't really understand what they're getting into.

Hess says his colleagues are often horrified when they hear that he spends some $25,000 a year on research software. It's worth it, he says, to get "perfect information at his fingertips" about most investment products, with the exception of SMA providers, whose reporting is much less transparent, he says.

Interestingly, data from Morningstar, Inc., which is available to advisors as part of Morningstar's Advisor Workstation Web-based software platform, finds that gross of fees, separate accounts representing the large-cap growth, blend, and value sectors outperformed mutual funds in the same categories over the five-year period ended September 30, 2006, by 34 basis points, 61 basis points, and 66 basis points, respectively. Morningstar Separate Accounts Director Steve Deutsch observes that managerial, advisory, or overlay manager fees can alter an investor's net results considerably, however, as can tax efficiency and portfolio customization.

Hess raises an eyebrow at the Morningstar findings. Based on the Schwab database of funds he considers to be a reliable source for SMA research, the best-performing large-cap value equity fund for the same five-year period was the John Hancock Classic Value Mutual fund, which returned 14.6 percent net of fees, while the best-performing SMA for the period was the Neuberger Berman Social Responsibility Equity fund, returning only 11.08 percent net of fees.

However you slice and dice the numbers, Strange maintains that it is now incumbent on advisors to move from their traditional focus on product and begin to better understand the sponsor's manager selection, asset allocation and portfolio construction procedures. "In the past, advisors have gravitated toward performance and 'hot' products. This is not a terrible thing," Strange says, "but in the future, I think they will need to become more comfortable with understanding a consistent, repeatable investment process governing their clients' portfolios."

SMA standards: First toe in the water

Imagine being a money manager with five telephones on your desk, each one requiring a different password to function and each communicating in an entirely different language.

Essentially, that has been the case for years now in the separately managed account space, where asset managers and sponsors have sought to create a unified language and a single technology that would eradicate the elaborate and repetitive account set-up and maintenance procedures managers must now carry out in order to sit on multiple SMA platforms.

"I speak 'Spanish' to one firm, 'German' to another, 'English' to another," Mark Pennington, a partner at Lord Abbett & Co. and chairman emeritus of the Money Management Institute, told an interviewer recently. In fact, Lord Abbett, which manages about $20 billion in SMA assets, maintains a staff of 50 to handle communications with the 10 different brokerage firms it uses.

Something had to give, according to the MMI, which has been pushing for standardization for the past five years.

Last September, Citigroup Inc. announced that its Smith Barney brokerage arm would begin adopting the organization's newest communications format early next year. The plan calls for money managers to begin sending information through the Depository Trust & Clearing Corp., which has been performing services for the mutual fund industry since the 1980s.

"What DTCC did was to create one 'phone' system," rather than the hodgepodge that currently exists, observes consultant David Gardner, whose Charleston, W.Va. company, Ficon, has been hired by DTCC to help launch the communications initiative. The idea, he says, is to establish a standard, open-architecture technology to trade and maintain client information using a single, XML-based language.

Smith Barney refused to comment, but the company will reportedly be aided in its own efforts by its Transaction Services unit, which is expected to help translate "SB speak" into the new MMI standards, as well as collaborate with DTCC on a service to automate the way new accounts are opened.

Will the communications initiative fly, and if so, will it really translate over time into quicker, more affordable SMA transactions and more extensive product offerings? There are no guarantees, says Cerulli senior analyst Jeff Strange. "I think the biggest hurdle is that the industry is going up against a lot of its own history," he says. "I hope it works, because it's too bad the industry has grown up in a way that's so inefficient to so many asset managers who should be concentrating more on managing money, rather than on the nuance of each different sponsor interface.

"I'm all for standardization in this industry, and I think Smith Barney getting on board is an important step that hasn't been achieved in the past, but I don't know how influential that will be with other large sponsors," he admits.--JA

Rise of the UMA

UMA development since the first quarter of 2006 asof last November, by nine SMA sponsors reporting to Cerulli:

AUM ($ billions)3Q 2006 growth

1 Wachovia$11,623 N/A

2 Morgan Stanley9,659 6.7%

3 Lockwood Financial/Pershing 714 N/A

4 RBC Dain Rauscher 594 22.1

5 LPL Financial 521 39.7

6 Standard and Poor's 516 14.4

7 Morgan Keegan 200 7.0

8 1st Global 161 37.6

9 Brinker Capital 120 50.0

Janet Aschkenasy (editor@janeta.com) is a freelance writer who wrote about 529 plans in the November issue.

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