David R. Evanson

Barron’s, Fall, 2003

You will get absolutely no respect at a cocktail party if you open a conversation by saying, “My mutual fund is rotating out of industrials.” A small crowd may quickly surround you, however, if you mention that an elite cadre of money managers has been fine-tuning your personal portfolio. Many investors are now able to do just that, thanks to the rapid growth of “separately managed accounts.”

These accounts, offered by banks, brokerages and fund companies, farm out your money to a handful of “best in breed” managers — say, one each for large-cap stocks, small-caps, international and tax-exempt bonds. The managers, in turn, buy and sell securities based on your preferences for asset allocation, industries and individual companies.

That sort of treatment once required an investment of at least $1 million, but now, thanks to advances in information technology, itzzs available to investors with as little as $300,000. And more and more people are signing up.

In fact, SMAs have been one of the few bright spots in the asset-management business. While mutual-fund assets have contracted 3% annually since 1999, SMAs have grown by almost 7% a year and now number 2 million accounts with $443 billion, according to the Money Management Institute, a trade group in Washington D.C. Whatzzs more, the group projects there will be 12.5 million accounts with $2.1 trillion by 2011. Yes,thatzzs trillion, with a T.

Almost all large financial outfits are getting in on the act, but the biggest players are the top brokerages. Smith Barney, Merrill Lynch, Morgan Stanley, UBS, and Prudential together account for about 80% of the SMA market.

There are some clear downsides. SMA fees, for instance, can be significantly higher than those of mutual funds. But other features of the accounts, including promises of tax efficiency and customization, make them well worth a look.

Does an SMA make sense for you? Herezzs a rundown on the key features.

My Basis is Not Your Basis
The most compelling feature is tax management, says Lori Heinel of SEI Investments, Oaks, Pa., which helps some 3,500 brokerages, trust departments and advisors run SMA programs. “With separately managed accounts, there are no surprises at tax time,” she says. “Investors own securities directly and establish their own basis.”

Heinel is alluding to the double whammy many investors got from mutual funds over the past three years. “When you buy mutual funds, you are buying an imbedded basis, and may end up paying taxes on gains you did not enjoy,” she says. In a worst-case scenario, played out in real life for many in late 2000, mutual funds delivered huge capital-gains liabilities just as the marketzzs swoon drove down their net-asset values.

Another tax advantage: SMA managers donzzt have to face mass redemptions and the consequent need to sell securities. That kind of selling, too, can generate big tax bills. As a sign of how taxes can eat into mutual-fund gains, equity fundszz load-adjusted 10-year return, 7.56% , falls to 5.53% after taking taxes in account, according to fund-tracker Morningstar.

Of course, some funds fare better than others on taxes; index and closed-end funds can prove quite tax-efficient.

Managing the Manager
Many investors are drawn by the lure of shaping their own portfolios. SEIzzs Heinel says that investors, through their adviser or broker, can instruct managers to avoid or bulk up on certain kinds of investments. “Someone who works for IBM, with a lot of in-the-money options, can design their portfolio to stay away from the tech sector to avoid a concentration of risk,” she says. Or investors can make sure their portfolios are free of stocks they find socially objectionable — say, tobacco shares.

More broadly, you can adjust the asset allocation to reflect changing circumstances in your life. For instance, if youzzll be getting a lump-sum pension payment, requiring an income-tax payment, you may want to scale back the income-producing portion of the portfolio.

But beware: If you donzzt take care to specify your preferences, you could end up with a portfolio that looks a lot like those of other investors in the program. Thatzzs why some critics see SMAs as mere “separately managed mutual funds.”

No Butlers
Many money managers have built-in resistances to being told how to do their jobs. And in an SMA, most wonzzt take kindly to frequent changes of instruction from you. If you want a “money butler” at your beck and call, youzzll have to stash $1 million or more with a private banker or traditional investment manager.

Likewise, donzzt expect your managers to be a complete breed apart from the folks who run mutual funds. Thatzzs “often part of the sales pitch, but itzzs not the idea you want to get sold on,” says SEIzzs Heinel. “Truthfully, almost any money manager worth having is a subadviser to a mutual fund.”

Wow, Those Fees Look High!
There are four players in a separate account program, and they each have to get paid. Your broker or adviser, who helps decide on asset allocation and communicates with the managers, gets 0.50% to 1% of assets a year, depending on how much you invest. Your money managers collectively will earn between 0.35% and 0.70%, somewhat less for fixed income. The SMA sponsor, which is typically an outside firm like SEI and handles reporting functions, gets 0.25% to 0.65% basis points. And the clearing and custody agent, which is sometimes the sponsor, may earn 0.15% to 0. 35%.

Adding it all up, the total on the low end is about 1.25% and on the high end about 2.7%. Investors with $300,000 or less will pay the most, while those with $3 million or more will pay the least, says Len Reinhart of Lockwood Financial, a Malvern, Pa., firm that works with 1,800 brokers and advisors on SMAs.

The fees can seem high compared to the average expense ratio for mutual funds — 1.42%, according to Morningstar. But remember, fund investors might also have to pay a front-end sales charge. And SMA customers can sometimes haggle to cut their fees by as much as 30%, says Ryan Tagal, an SMA specialist at Morningstar.

The Payoff

Even after negotiations, SMA fees can end up higher than those of funds — but the returns may be higher too. According to White Plains, N.Y., based research firm Effron, SMA managers handling U.S. equities returned an average of 10.96% for the past 10 years, before expenses. That compares with 7.78% for equity mutual funds, says Morningstar.

Why the strong showing? For one thing, SMA programs are constantly culling out poor-performing managers, while the mutual-fund tally includes the good, the bad and the ugly.

Indeed, one of the most useful things that SMA programs do is to monitor the performances of your money managers. And managers say the oversight is intensive, including quarterly reporting, due diligence visits, and random checks on the rationale behind specific trades.

“I think the guys doing oversight must be ex-FBI or CIA,” says Mark Pennington, a partner at investment management firm Lord Abbett. “Itzzs gruelling, but it makes me feel good these guys are really looking out for investors.”

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David R. Evanson is a financial journalist in Swarthmore, Pa.

(See related letter: “Barronzzs Mailbag: Fighting for Fees” — Barronzzs Sept. 15, 2003)