The separately managed account revolution might well be sweeping the financial services industry — transforming sales-junkie brokers into fee-based financial consultants with the knowledge to design and implement financial plans for a client over his lifetime. That transformation, while still somewhat slow, is inexorable, but also incomplete. So far, for the most part, SMAs aren't being used correctly.

“Too many advisors are using them like a mutual fund, an expensive mutual fund,” says Gina Fabro, a manager analyst at Moneta Group in St. Louis. “Advisors are just putting clients in managed accounts and then walking away, as if the portfolio manager knows what you want him to do for your client.”

SMAs are theoretically supposed to be superior to mutual funds because the portfolios can be customized to fit individual clients' needs. The fact of the matter is, mutual funds are, for most people, a perfectly fine way to invest. They are relatively cheap, and the vehicle's structure, having been around since the 1920s, works just fine. But, SMAs are particularly good for wealthy clients, because you can ask the portfolio manager to sell A for a loss to offset a capital gain somewhere else. Or you can tell the manager not to buy any stocks in, say, the technology sector since your client works for IBM and has a large holding in that stock. All this is possible, of course, because in an SMA, clients own the securities in the portfolios outright — and not shares in a mutual fund.

But let's face it: For SMAs to work well for a client, they must be used correctly. For starters, only about 10 percent of functioning brokers out there are even using SMAs, according to the Money Management Institute. And about half the accounts opened today are getting only one manager, according to Kevin Keefe, a senior consultant at Financial Research Corp. In part this is due to lower account minimums, which have dropped from $1 million to $100,000 (and sometimes lower), which makes it hard to adequately spread money across enough different styles. “I don't think it's worth it for someone with $100,000,” says Fabro. “You only get one manager, and that's not proper asset allocation. You want at least five to six different style boxes on the equity side, alone, so clients really need at least $1 million.” That number differs from advisor to advisor, but clearly $100,000 is certainly not enough to ensure proper diversification.

Compounding the problem is that the average broker uses only 3.1 managers for all accounts, says Chip Roame, managing principal of Tiburon Strategic Advisors, a Tiburon, Calif. consultant. “So the broker picks three favorite managers and keeps selling them,” he says. “There's some concern that diversifying among managers isn't really being applied correctly.”

Moreover, since the top 10 money managers control one-third of all SMA assets, many clients wind up in the same model portfolios anyway, making it hard to justify how the advisor is really adding value. And as mutual fund companies attack the managed account business, increasingly, SMA managers can be accessed through mutual funds anyway. “We find the distinction between mutual fund and SMA managers has been blurred to the point of insignificance,” says Tom Samuels, chief investment officer at Stavis/Margolis Advisory, a member of Royal Alliance, in Houston. “The point is, it's not about which vehicle you use. That distinction is spurious. The point is, are you using the right strategy and the right manager for the client?” In fact, many mutual fund families now offer managed account version of their mutual funds, such as MFS, AIM and Alliance to name but a few.

Read the Instructions

Nor do most SMA clients seem to be reaping the advantages that the vehicle is theoretically supposed to provide — rebalancing, active tax optimization and customized stocks picking. Leaving portfolios alone is not what sophisticated investors do. For example, in 2001, 91 percent of institutional investors rebalanced their portfolios in some way, according to Greenwich Associates. By comparison, only 23 percent of affluent investors rebalanced, according to a Phoenix Investment Partners survey.

Other features of SMAs that supposedly make them superior to mutual funds also seem to be underused. Brokers are supposed to consciously offset capital gains with losses through SMAs and restrict stocks to avoid over-concentration in a company or industry. Most brokers don't seem to bother with such services. “About 14 percent of accounts actually get customized,” says Roame. “If that's such a great advantage, why don't I see more of it?” Needham, Mass.-based market researcher Cerulli Associates reports that only 30 percent of separate accounts request customized tax treatment. “Most brokers don't use those features,” says Fabro. “They tend to sell the package as a product and then let it run.” Of course, in a bear market there is less of a need to sell losers to offset the winners' tax bills. These days, funds hand investors plenty of tax losses that can be used against future gains.

Some brokers blame the problems on the structure of SMAs themselves, claiming they lack sufficient flexibility when the market tanks. “Rebalancing and all of that are the icing on the cake, but the cake stinks,” says a rep at a top-five brokerage firm. “Those are nice features, but if the client is down 41 percent, what good is rebalancing?” He argues that sticking rigidly within one style box has turned separate account managers into “closet indexers” who can't raise cash or switch sectors to protect clients against precipitous market drops.

“Separately managed accounts are fairly blunt instruments,” agrees Samuels. “We want a sharper knife. If the market is going to be flat or down, it's easier for me to say, ‘I love you, but your style is going to be out of favor for a while, so I'll take $250,000 and put it in something else.’”

To be fair, SMAs that are adequately diversified should be able to withstand market downturns better, but if clients aren't adequately diversified then something's wrong with the process. Brokers need to look more to multi-discipline accounts, or MDAs, to address adequate asset allocation. MDAs are essentially a fund of funds SMA — several different management styles in a single account with an übermanager as overseer. This way smaller investors can achieve a higher level of diversification. According to FRC, they are the fastest growing segment of the SMA business but are still a small part of the market.

As for customization features like rebalancing, tax-loss harvesting and other supposed SMA advantages, brokers have to rely on a combination of the mechanical and the human touch. They'll need to depend upon technology platforms that help them customize as efficiently as possible across an increasing range of variables — or be crushed by the sheer volume of paperwork. Anyone still trying to provide these features manually will fall by the wayside; it's just too complex, especially as more clients learn about these features and want to see them in action. “It's not humanly possible to add value if we can't reduce the labor intensity of a financial advisor through processing technology,” says Stephen Winks, an industry consultant.

He and many others agree that the SMA floodgates won't open until financial services companies accept some kind of uniform industry standard for both technology and communications between the various parties involved in SMAs. But in the meantime, brokers need to explore what software platforms are out there. Turnkey solutions offered by Placemark Investments or Tamarac do the asset managing and customization and leave the broker more or less free to gather assets, visit current clients or accomplish more relevant tasks. Optimization platforms like Oberon create an interface with outside managers and throw customization values into the messages going between advisors and managers.

Time and Money

To use these, of course, reps have to invest time and money to learn not only how different platforms facilitate managed accounts, but also to understand how managed accounts work. There's a steep learning curve involved, and while brokerage firms have fee account conferences and systems support for advisors, training and support resources are harder to come by outside the top five wirehouses. “At many firms, there simply isn't any budget for education,” says Lewis Walker, of Walker Capital Management, an independent financial planner and advisory firm in Norcross, Ga. “We have a high payout but a lot of expenses like rent, staff, equipment — that leaves precious little for training.”

FRC's Keefe advises reps to leverage the support from the asset management firms to explain exactly what their processes are and how both you and they fit into it.

Many of the technology companies will also put time into training reps if you're willing to approach them. Placemark, for example, walks advisors through the flows of managed money, the process of getting managers up and running, when and how they report, and how trades take place, so they can explain it when clients want to know why a certain trade occurred. “If advisors don't know that stuff, they won't be able to answer their client's questions and will be frustrated by the process,” says Placemark CEO Lee Chertavian. “The more we can educate them, the more they'll rely on managed money.”

As the lynchpin between the managers and the client, the advisor has to know how to do due diligence on either end. They need to understand more than just the manager's style but how he handles risk, his buy and sell disciplines, sources of research, and corporate changes. “Advisors tend to gyrate toward recent performance rather than focusing on a good screening process performance,” says Mike Benoit, managing director of the Wealth Office at DiMeo Schneider & Assoc., an investment consultancy in Chicago. Down the road that means they'll have to change and go manager-hopping. “Don't take it for granted that a manager is a good choice; back it up with a good reason,” says Benoit. “If you've done your homework, you should expect to keep that manager in place for a whole market cycle.” (For more on choosing a manager, please turn to page 54.)

Even more than their managers, advisors have to know their clients inside and out to maximize service to them. It's not uncommon for clients to withhold information, while advisors in turn are reluctant to invade the client's privacy. But not knowing enough is the surest way to botch the job. One client in 1999, for example, took $100,000 to each of three different firms, asking to invest it with the manager who had performed best over the past five years. Each firm put her in a large-cap growth portfolio. Consequently, she lost 70 percent of her investment. “Nobody should have let that woman open a single account without other asset classes,” says Stephan Gresham, chief sales and marketing officer of Phoenix Investment Management and author of The Managed Account Handbook.

Advisors have to be rigorous in gathering client information about the extent of their assets, where and how they're held, especially if it's with other companies. “Brokers need to challenge the client about all of the possible needs they might have for their money,” Gresham says.

Brokers also need to be careful to choose clients who are appropriate for the SMA process. “The biggest trip-up is improper client selection,” says Gresham. Clients who want to control the investment process or who easily panic will second-guess the advisor and pressure him into chasing the latest hot-dot managers or selling holdings at the worst time. “It's really hard for an advisor to walk away from business,” says Gresham. “But that's what professional standards are all about. Just because the customer has the money doesn't mean he's right in this case.”

It helps to remember the institutional origins of SMAs in establishing a good advisor-client relationship. Most mistakes, such as performance chasing and failing to rebalance accounts, are violations of institutional investment practice. Moreover, you can't underestimate the service requirements of SMAs, says FRC's Keefe. “At least once a year, you need to talk to people about their portfolio performance, asset allocation, taxes and rebalancing,” he says. Part of the sea change from a transaction-based to a fee-based culture is understanding that the service “doesn't begin and end with the sale.”