The New Wave

While the Citigroup MDAs succeeded in solving a piece of the operational puzzle, it did not address the labor-intensive customizations and tax-loss harvesting sometimes employed in traditional separate account programs. Further, there was no effort to fundamentally change the way client accounts were managed as a function of having all of the client’s managed assets in a single account. Tax efficiency in these MDAs was, and largely still is, achieved at the direction of the client’s advisor in a somewhat ad hoc fashion, if at all. Nevertheless, the introduction of MDAs served as a wake-up call since it showed what could be done in delivering better products for clients. As broker/dealers, trust companies, and other firms that serve high-net-worth clients looked to offer their own competing multiple style portfolio products, the market for overlay portfolio management services began to gather steam.

Historically, tax management or other client-specific customization has been done by the money manager in conjunction with the advisor. To the extent it caused dispersion, or differences between client accounts within a single manager’s model, tax management was seen as undesirable, since it led to operational complexity and differences in client returns that were often hard to justify. As a result, rather than acknowledging the unique attributes of each client and managing each account in a different manner, separate account program sponsors have been motivated to manage client accounts in a uniform fashion, minimizing dispersion.

This is largely a function of how SMAs evolved, which was based primarily on the needs of institutional (and tax-exempt) clients. Even today, most deliver a largely “institutional” product with no regard for taxes. These portfolios are then leveraged into as many channels as possible by the investment management firm’s sales force. Few investment management firms, even those with significant distribution in the separate account market, are set up operationally to customize large numbers of client portfolios, or to coordinate their trading activity with the trading activity in their clients’ other portfolios.

Overlay portfolio management provides the technology to oversee the activities of all of a client’s managers, while considering taxes and risk management in the context of a client’s entire portfolio. The overlay portfolio manager’s role, and overarching value to the client, is to coordinate all of the client’s trading activity and investment decisions in the context of that client’s tax and risk situation. Clients have their own risk/return tolerance (lambda), cost basis on all securities, outside gains and losses, unmanaged assets such as company stock, and other factors that can radically change how a client’s assets should be managed, and the after-tax returns that can be realized via that management process.

One way to deliver these customized portfolios is to decide what needs to happen at a client level, and then communicate those client-specific decisions to each individual manager for incorporation into their individual portfolios for the client. The complexity of such a process becomes apparent when one considers the level and frequency of communications and coordination required. The events that would need to be communicated include significant gains and losses outside the portfolio, the trading of each manager within the client’s assets that generate any gains or losses, the need for cash withdrawals, and any change to the client’s investment objectives.

Beyond simple notification, each manager would need to have an investment management process that could use this data to customize each client’s account for risk and tax management. This is a capability that almost no investment managers have today. Again, overlay portfolio management offers a solution by assuming discretionary control over all accounts and customizing the application of the investment managers’ data to each client’s account in a consistent manner. To the money manager, an OPM looks like a single, large, institutional non-discretionary account. As the money manager’s best information changes (as expressed in model portfolios, lists of alternate securities, and even opinions on individual securities), the OPM acts on that information in the most appropriate manner for all clients.

The obstacle that keeps separate accounts from being managed in a highly personalized and tax-efficient manner today is cost and operational efficiency. Taxable accounts of several million dollars often do receive this level of treatment by their advisors and money managers, but scale for delivering highly personalized and tax-optimized separate accounts will only be achieved through the use of advanced technologies and overlay portfolio management disciplines.

How OPM Helps Advisors

This new way of managing client assets will create a much higher demand for advisors. For the first time, advisors will be provided with an investment management process that can actually leverage all the information they collect about their clients, leading to improved risk management and after-tax returns. The costs of OPM are generally buried in the management fees of the product, usually at a price comparable to existing separate account management fees, though sometimes at a relatively small (five- to fifteen-basis-point) premium. When compared to the 30 to 70 basis points of improved after-tax returns that can be achieved, along with superior customization, risk management, and tax management, the benefits to advisors and their clients become clear.

Historically, advisors had limited impact on the management of client portfolios, and instead have focused on planning, asset allocation, and product selection. Using an OPM, advisors can be directly engaged in investment management decisions, providing the input for delivering highly personalized, tax-optimized products. The result will be a more attractive product available to a broader range of investors, and a more valuable role for the advisor.