The SMA Migraine

Separate accounts have been the “it” product for the financial advisory business for several years. They are so alluring — promising to align the interests of clients and reps by making the rep a fee-based asset manager rather than a commission seeker. They provide ordinary investors with both access to top money managers and customized portfolios. And they promise tax efficiency, protecting investors from the surprise tax bills that sometimes come with mutual funds.

So, why have money managers cooled to this seemingly irresistible financial confection? Because, it turns out, SMAs are a costly operational and administrative nightmare for managers and not nearly as profitable as other products. Although they are more expensive than mutual funds to the retail client, SMA managers are making less money off them. Money managers, on average, collect 75 basis points for running a portfolio on an SMA platform, according to Chicago-based Morningstar. This is substantially less than they would earn managing a mutual fund, which often pays 100 basis points in management fees (before breakpoints). Broker/dealers are able to squeeze SMA managers on their management fees, but don't pass along all that savings to their retail clients. In the end, then, very often the client pays more, broker/dealers make more but SMA managers make less.

In addition to taking a pay cut, managers learned quickly that executing and accounting for trades in hundreds or thousands of individual accounts was wildly expensive, particularly if a manager chose to do the work in-house. There were investments in new technology and more staff to monitor execution. Furthermore, there were additional marketing costs to hire more salespeople and/or pay for wholesalers. Between compressed fees and added expenditures, SMAs produced anemic profit margins for the managers.

“The money management industry got excited about the SMA business, jumping into it without considering the operational difficulties and sales commitment,” says Scott MacKillop, president of U.S. Fidelity Services in Sugarland, Texas. A lot of managers now find themselves stretched too thin because they underestimated the costs and effort required to support SMA products, he says.

I Want My SMA

At the same time, demand for SMAs continues to grow because they are appealing to investors. Assets held in separately managed accounts increased by $29.9 billion during the second quarter, reaching $620 billion in June 2005, according to the Money Management Institute (MMI). This is a 7.8 percent increase since last December, and a 17.3 percent spike from June 2004. The number of individual accounts passed the two million mark in January — an important milestone — and now stands at 2.08 million, a 5 percent increase from mid-2004. The average account size, too, has risen, by 10.7 percent to $298,232, from $269,422.

Wirehouses and b/ds like SMAs too. Many firms have been leaning on their reps to do more SMA business, say analysts. They see SMAs, with their customization and tax benefits, as great tools for attracting high-net-worth clients. SMAs also fit into b/ds' efforts to stabilize their revenue streams by increasing the percentage of revenue they derive from fee-based client arrangements, says Chris Cosentino of MMI. Indeed, Smith Barney and Merrill Lynch, the two firms with the largest separate accounts platforms, recorded double-digit asset growth in the 12 months ended June 30. Assets in third-party manager separate accounts at Smith Barney grew 14 percent, to $115 billion, and at Merrill Lynch rose 13 percent, to $109 billion.

The advisors' attitude towards SMAs, however, are complicated. On the one hand, the product helps satisfy the demands of the most desirable clients. But some advisors say SMAs are more hassle than they are worth. One advisor views SMAs as “glorified mutual funds” with outrageous fees.

Michael Palmer, a planner at the Trust Company of the South in Raleigh, N.C., says he withdrew from the SMA business because one of the largest providers stonewalled his firm every time it requested a particular manager. In at least one instance, Palmer says the manager he had requested turned in a better performance than the platform choice. On top of that, there were inefficiencies related to the custody of the accounts, he adds. “Operationally, they were a headache.”

Money managers have the biggest issues with SMAs, however. The proliferation of SMA choices has created intense competition among managers. According to Cerulli, there are 120 SMA manufacturers trying to get a slice of the advisory business. Few managers have achieved economies of scale, and more than a few see the effort as not worth their while. Because of the high cost of retail SMA marketing, some small money mangers have already scaled back efforts to sell SMAs through reps. “When you [have to] put the infrastructure in place, it starts compromising resources,” says Jim Lobb, managing director of Philadelphia International Advisors, a privately held investment management firm with $5.6 billion in assets in Philadelphia. Lobb limits his exposure to the retail SMA business at 10 percent of his assets, opting to focus more on garnering institutional money.

Even some of the top money managers in the country are rethinking their retail SMA strategies. One of the largest firms on Wall Street (which a source insisted we not name because doing so would expose his identity) has quietly capped its exposure to managed accounts at 25 percent of assets, versus a 75 percent weighting in mutual funds. The reason for the shift is clear: Mutual funds boast higher fees and lower costs.

Getting on the Shelf

So, why do money managers still put so much effort into SMA products? Some managers argue that separate accounts are a “necessary evil” in the sense that while the profit margins are less than enviable, they do provide a means for getting deeper distribution. “It's the only way you can get brokers to recommend you,” says Barry James, CEO and portfolio manager at James Investment Research in Alpha, Ohio, a family-owned shop with $225 million in retail SMA assets. Offering SMAs helps grow the firm's asset base, which builds credibility in the marketplace and opens doors that wouldn't otherwise be accessible. In other words, capturing retail SMA money can get managers the necessary shelf space they need to reel in well-heeled clients.

James says he tolerates the “expensive systems and thinner revenue” of the SMA biz because he is betting on a huge payout in the long run. He has already seen dividends. And his foray into the SMA arena has also generated a decent amount of institutional business.

“It's very difficult to get access to the more senior, corner-office consultants,” says Eric Anderson, a longtime SMA marketer and former director at 1838 Investment Advisors. He says that it pays for managers to lead with SMAs because of their cachet. As wealthy clients told Registered Rep. in exclusive research this summer (see “You Say, They Say,” September 2005), they want their advisors to bring them unique products and access to elite managers, not the mutual funds that ordinary investors use. Once a money manager gets a foothold with an SMA offering among the reps that serve such clients, Anderson says, it can then sell a full range of products.

“Nobody is really making money on these things,” says Dave Haywood, a senior analyst at Financial Research Corp. in Boston. “It's a product used to gain access to distributors, a gateway to the affluent advisors.”

Risky Business

On top of the costs of marketing and administering SMAs for retail investors, money managers are facing another reality: Separately managed accounts can be an extremely risky business. Several shops have been forced to exit the business, either because they couldn't achieve economies of scale or the bottom dropped out of their performance.

1838 Investment Advisors, which had $14 billion under management at its peak, got whacked when its large-cap core strategy tanked in early 2000. It lost half of its assets. Eventually, the King of Prussia, Pa.-based firm was booted from major brokerage platforms at Smith Barney, Legg Mason, Prudential Investments, First Union and LPL Financial. Institutional clients bolted, too, and the firm closed its doors quietly in June 2005.

The average SMA portfolio has trailed the performance of the average open-end mutual fund on a one-year and three-year basis, according to Morningstar. But SMAs have a better long-term track record, posting a 5.39 percent return over the last five years, whereas mutual funds have generated a 2.09 percent gain. Over three years, mutual funds posted an 11.85 percent return, slightly higher than SMAs, which notched an 11.33 percent gain. So far this year, mutual funds are beating their customized counterparts with a 3.09 percent return, compared to SMA gains of 2.18 percent, as of Aug. 31.

“The volatility of the SMA business scares managers,” Lobb of Philadelphia International Advisors says. An SMA manager can lose its slot on a platform at a moment's notice, simply by tweaking its investment strategy or losing key personnel.

Talent Drain?

The biggest problem, many money managers say, is their lack of leverage with the wirehouses. These few firms control 80 percent of the SMA assets held by retail customers and can dictate terms. “You're at the mercy of the wirehouses, who can lower your fees and decide whether you're in play or not,” James says. “But you have to dance with whomever is on the dance floor.” The few dominant players in the space dictate the pricing model and can reshuffle the manager lineup at any time, which, from a managers' perspective, is not the preferred way to run their business.

Nobody is predicting the demise of the SMA product. But, as things stand now, the prospects are dimming. One of the more alarming possibilities is that the top-caliber managers — the bait used to bring affluent clients into the SMA business — will get out of the managed account business and focus on mutual funds or hedge funds, where the compensation is better. The SMA business, in other words, may be left to managers that can't command top dollar. “Fee compression will limit the number of managers on a platform and degrade the quality of the money managers, creating a short list of managers handling a little bit of money,” says Mark Pennington, a partner at Lord Abbett in Jersey City, N.J., and chairman of the MMI.

“It will take cajones, but there will come a time when a manager stands up and says, ‘That's enough,’” says John Daly, a longtime managed-account marketing executive who is not currently affiliated with a firm.

Finally, the icing on this not-so-tasty cake could come in the form of increased regulation. “The success of an asset class inevitably leads to more stringent regulation and further standards,” says Morningstar analyst Steve Deutsch. Already, the CFA Institute, a trade association for investment professionals, has issued new guidelines for money managers regarding how performance data for SMAs should be presented to investors.