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Separate accounts: what technology is needed to succeed with this product?

A staff reporter

13 February 2005

Separate accounts are an investment product sold to individual investors under an investment consulting relationship —but the product has assumed many other names. Until recently, they were known as a "wrap account" because of its fee structure. Typically, the investor is charged a fee that is a percentage of assets invested. The single fee, usually paid quarterly, covers portfolio management, trading commissions and other transaction costs, custody, account administration and reporting services. The wrap fee is usually in the neighbourhood of one per cent to three per cent per year of the assets being managed. The advisor or investment consultant that the client enters the relationship with is usually selling the product on behalf of what is known as a "wrap sponsor firm" — typically a broker, investment bank or other institution with a large retail client base. The assets in the account are managed by a professional money manager of the same calibre as those that manage assets for institutions. In the last few years, the industry has shifted to different names for this type of account to focus more on the characteristics of the product being offered than the fee structure charged for it. The most common names for this type of account include: separately managed accounts (or just separate accounts), individually managed accounts, or simply managed accounts. Commonly used acronyms are SMAs or IMAs. A brief history Hutton Investment Management, under EF Hutton, introduced the first managed account product in 1976. Hutton was essentially the sole vendor for this product well into the 1980s. In 1987, Merrill Lynch started its Consults fee-based programme, and Prudential and PaineWebber also started their own programmes. After these were launched, the separate accounts industry began to define itself with different types of programmes such as consultant wrap and mutual fund wrap (these terms are explained below). The industry has had consistently significant growth over the last several years, with $392.57bn in assets under management at the end of the first half of 2002. Types of separate accounts The products available in the separate accounts marketplace fall under the following five categories, as defined by Cerulli Associates, an international research and consulting firm: Consultant wrap: programmes in which managers that are typically unaffiliated with the wrap sponsor manage investors' assets in separate accounts. These accounts may hold various types of stocks, bonds and other securities. Account minimums normally range from $100,000 to $250,000, and fees are often between 2.5 per cent and three per cent (this is about 40 per cent of the market). Mutual fund wrap: programmes which diversify investor assets across mutual fund securities. Account minimums are typically between $10,000 and $50,000 and fees are typically in the neighbourhood of 1.25 per cent (17.5 per cent of market). Proprietary wrap: discretionary fee-based separate account programmes that are managed by a sponsor firm's internal asset management division (11.5 per cent of market). Rep as portfolio manager: programmes in which financial representatives act as money managers for their clients, after undergoing rigorous training (ten per cent of market). Fee-based brokerage: programmes in which active traders pay an asset-based fee (normally around one per cent) for all trading rather than paying commissions on individual trades. These programmes may or may not offer advisory services (21 per cent of market). Why separate accounts? Mutual funds were the last big innovation to hit the individual investor market place. The mutual fund industry provided investors with a product that was diversified, professionally managed, liquid and relatively inexpensive. For the first time, many investors had access to the same expert money managers that were hired by institutions. Technology and distribution channels improved to such a degree that, when coupled with investor awareness and education, they allowed the mutual fund industry to boom during the 1980s and 1990s. In 1979, the American mutual fund industry had $94.5bn assets under management. This amount grew to $6.6trn in the second quarter of 2002. Mutual funds effectively became a product that was as commonplace, easy to understand and to obtain, as a loaf of bread. In today's world, virtually all investors understand what a mutual fund is. Mutual funds do have some weaknesses, however. The main weakness is that mutual funds are not a customisable product. When an investor buys a mutual fund, they are buying a piece of a portfolio that they share with what could be millions of investors. This poses several problems for the investor: A purchase of fund shares is also a purchase of the historical unrealised gains of the fund's securities, which carry a hidden tax consequence for the investor. When other investors redeem fund shares, the fund manager may have to liquidate securities, resulting in realising capital gains that then cause the investor to suffer a tax consequence when the investor has not necessarily actioned a trade. The fund manager must constantly balance the investment strategy against the purchase and sales of fund shares made by investors. A fund manager cannot employ any investment restrictions or guidelines that the investor may have. Customisation of investment portfolios is a key issue for individuals, especially in the high net -worth segment of the market. In the same way that wealthy individuals want their cars made with options specific to them and their houses built with unique features, they also want their investment portfolios to be tailored specifically to their objectives. The high net-worth individual is the key target client of the separate account product (more details about the growth of this market segment are below). Other issues that are weaknesses of the mutual fund product: Lack of transparency: investors can only see what is held in the fund only periodically – usually quarterly – so it is difficult to determine whether the fund is providing an investor with the market exposure desired, and it is also difficult to track how the manager responds to market conditions. Lack of efficient tax management: studies suggest that investors in mutual funds lose between 130 and 250 basis points of their return to taxes. This is a significant portion of any investor's total return. Beyond the tax issues cited above, much of this loss comes from inherent characteristics of a mutual fund – as an institutional portfolio, it is not subject to taxes. This is in direct contrast to the needs of the fund investor who typically pays taxes, and in fact there is a great variety in the tax profiles of the different investors in a given fund. The managed account product offers HNW clients a product that is similar to mutual funds in that it is also liquid, diversified and professionally managed, but in an structure that: Allows the money manager to tailor investment decisions to an investor's objectives and investment horizon. Allows the money manager to incorporate any investment restrictions or guidelines (e.g., no sin stocks). Enables the advisor or consultant providing the product to do so on a platform that provides the transparency to see the account's assets much more frequently than with a mutual fund – up to daily. International market The international (non-US) segment of the SMA is already sizeable, at just under $70bn at the end of 2001. Cerulli Associates found in their 2001 survey of the international wrap marketplace that several major players in American wrap are making inroads abroad. These include Citigroup's Salomon Smith Barney, which had $2bn in assets under management, as well as UBS Private Banking, which had moved into five European countries and had plans to move into the Far East. Other companies involved in international wrap include Morgan Stanley, Merrill Lynch and SEI Investments. The $70bn in international separate account assets does not include the Italian gestioni patrimoniali in fondi market, which held more than $170bn at the end of 2001. The GPF product is very similar to separate accounts, but lacks some key attributes such as automatic rebalancing. Other signs that the market will continue to grow rapidly include the fact that companies that traditionally have not offered separate accounts are now working on ways to get involved and obtain their own slice of the HNWI's assets. This includes fund companies such as INVESCO, Rittenhouse and AIM, as well as distributors such as Schwab. What are MDAs? Multiple discipline accounts are the latest major innovation of the separate account product. These investment vehicles also go by several different names, including multiple-style portfolios and multi-manager portfolios or products. One of the basic tenets of modern portfolio theory is that the in order to maximise return while minimising rise, one should diversify their investments. Because money managers typically have segments of the market that they focus on (e.g., large cap stocks, technology stocks, entertainment stocks, non-investment grade corporate bonds), an investor in a separate account typically receives a portfolio that may be diversified with respect to the manager's specialty, but is not diversified with respect to the overall market. In order to become sufficiently diversified, the investor would often open multiple separate accounts, perhaps with different advisers. This then presented a problem to the investor in that it became difficult to obtain valuation statements that reflected their entire investment portfolio (i.e., statements that were consolidated across separate accounts). Furthermore, issues of overall tax management and diversification became difficult, since each separate account manager working for an investor would make investment decisions without knowing about the actions of the other separate account managers. For example, consider an investor with two separate accounts: one focused on growth stocks and one focused on value stocks. Suppose the former manager considers AOL Time Warner to be a growth stock and the other considers the company to be a value stock. This could result in a couple of problems for the investor: If both managers hold the stock in their separate account, diversification is not being achieved. If one manager sells the stock to harvest a tax loss and the other manager unwittingly buys it within 30 days, a "wash sale" is created which effectively nullifies the loss (in the US). The multiple discipline account solves this problem by offering multiple separate accounts through a single adviser. The MDA allows the investor to: Achieve diversification without entering into multiple adviser relationships. Receive consolidated statements and performance analysis on their investment portfolio that reflects all of their separate accounts. The multiple discipline account concept was introduced by Citigroup Asset Management, and many firms are racing to introduce this product offering to their clients. At the end of 2001, 3.5 per cent or $15bn of separate account assets were held in MDA products. Financial Research Corporation anticipates the portion of the separate accounts market devoted to MDAs may grow to 17 per cent of the total industry by 2004. In order to provide greater efficiency in the MDA product, the role of the overlay portfolio manager has been created. This individual sits between the adviser/consultant and the separate account discipline managers. The benefits of the OPM are: The OPM can take on the majority of the asset allocation responsibilities for the investor's portfolio, allowing the adviser/consultant to focus on client relationship management. The OPM is a single point of contact for the adviser/consultant, rather than the adviser/consultant having to interface with each separate account discipline manager. The OPM can provide portfolio oversight, including managing security overlap between the manager sleeves, avoiding wash sale scenarios, and managing the investor's diversification needs across the portfolio sleeves. In a sophisticated MDA, the OPM may tackle the issue of tax management, and orchestrate the investment decisions of the sleeve managers in order to maximise the investor's after-tax return. Portfolio management technology for separate accounts So what should a firm look for in a portfolio management solution for an SMA business? Strong multi-currency accounting: surprisingly, many sponsors today run separate account programs on software that does all of its accounting in a single currency. Investment advisors are inhibited by single currency systems, having to make a choice between limiting the investment vehicles they may use in their accounts, or being restricted by the limited reporting and analysis that such a system provides. When determining whether a system has strong multi-currency accounting, a firm should analyse the data entities (client, security, firm) to see that each is properly marked with a currency of denomination. The transaction data should be inspected to determine whether there are sufficient exchange rates to capture all money amounts (including cost bases) in the required terms (firm and client base currencies, security local and exposure currencies, trade settlement currency). This data will provide the foundation for all decision support, valuation reporting and performance measurement. If there are critical elements missing it will have a significant effect on other activities. It should also be determined whether valuation reporting and performance measurement can be carried out in terms of any currency for which the user has exchange rates. Robust handling of various securities: in the early days of the separate account market, almost all assets were held in common stocks. In today's world, however, diversification is key. The system must be able to handle all types of stocks (ordinary shares, preferred stock, depositary receipts) and mutual funds as well as the government and corporate bonds of various country markets. It is also becoming more common that separate account managers want to incorporate alternative investments such as exchange traded funds and hedge funds in their investments. The portfolio management system must have the functionality to handle these assets throughout – from portfolio modelling and trade placement through to asset valuation and performance measurement. Tax-intelligent accounting: the most valuable part of the separate account product is its customised nature. Tax profiling is extremely important to the SMA product, and the tax accounting capabilities of the system. Again, the firm examining the functionality of the system should look to the data entities in the system (client and security) and see if the attributes for these entities capture sufficient information to do proper tax accounting. Examine the data stored for tax rates, exemption rates and withholding rates. The tax-intelligence of the decision support capabilities at the portfolio manager's disposal will have much to do with the tax accounting inherent in the software. Fundamental tax-based decision support should provide managers with the ability to make proposed trading scenarios and see the potential tax consequences, prevent wash-sale scenarios, and allow tax profiling to be part of the client objective setting process. Users should not have to use paper to do this; rather, the software should accommodate automation of the process by allowing the client's tax profile to be defined in the system. Advanced tax-intelligent trade placement will allow managers to be reminded to repurchase a security after the 30 day wash sale waiting period, as well as automate the process of harvesting gains and losses and migrating new portfolios to the intended investment strategy. Performance measurement: in today's world, performance must be measured and reported in accordance with the global investment performance standards. Firms need software that allows them to be in compliance with the standards today, and also moving forward, since the standards require more from firms in the future (e.g., moving from monthly to daily valuations). Also, investors today are more aware and informed about the securities markets than ever before. This has manifested itself in an increasing number of investors knowing about the words "GIPS" and "time-weighted returns", even if they do not fully understand such terminology. Investors are also keenly aware that they should be interested in the after-tax rate of return, rather than the total pre-tax return on their portfolio, so it becomes imperative that the software has the capabilities to calculate and report such numbers to go along with the tax-based profiling, trading activities and valuation reporting that the system should support. Real-time, as-of reporting capabilities: one area where the separately managed account must provide an advantage to investors is in the timeliness of information, and the technology in place must support this. As an alternative to mutual funds, where the client's true exposure to securities, other than the top ten holdings, is known on a lagged basis (as much as three months), the positions in separately managed accounts should be known on an up-to-the minute basis. Again, as investors become more aware of the securities markets, they want this information available to them. The software solution in place should support the sponsor and/or manager providing access to this information on demand, via the internet or other distribution system. This should not be limited to asset appraisals alone – performance numbers should also be available at least on a daily basis. A firm should consider its needs in this area seriously when choosing a software solution. Internal and external straight-through-processing: a very significant consideration is how a given software solution helps or hurts a firm's STP plans. Many firms consider external STP — i.e., how connected is the system; does it have links to all of the necessary back-office systems, custodians, brokers; does it have SWIFT, ISITC and/or FIX functionality? Often overlooked is the internal STP — i.e., how the system integrates with other software solutions in use at the firm. If different systems are used for modelling, order management, portfolio analysis and reporting, and performance measurement and attribution, a key question is how easily is data transferred between these disparate systems? Do these systems use separate databases, do they communicate data in different formats from each other, how easily are they reconciled? In many cases a vendor with a modular system with a single integrated database may be a better choice from an STP point of view than to choose between several best-of-breed solutions and then try to link them together. Overlay portfolio manager tools: if a multiple discipline account product is being offered, does the system provide the overlay manager with the necessary tools to oversee the investment decisions of the sleeve managers? Are the necessary tools present to manage stock/security overlap, prevent wash sales and make tax-intelligent trade decisions? It is also critical that consolidated and sleeve reporting capabilities exist, for both asset valuations and performance measurement. Scalable, open architecture: many firms overlook their need to grow over time when choosing a portfolio management and accounting solution. The question of whether the system can handle the number accounts the firm has today should be asked — but will the system be able to handle the number of accounts that the firm plans to have in two, five, or ten years? If the company acquires other businesses, can those be folded into the portfolio system seamlessly, allowing each business group to provide its products in the way they choose to without interfering with each other? John D. Simpson is the director of application research at Integrated Decision Systems, a software firm which develops portfolio management, trading, decision support and performance measurement systems for the international investment industry.