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.
What Your Peers Are Reading
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.