David R. Evanson

On Wall Street, Spring, 2004

After almost three years, it was over. This past December, Callan Associates, Inc., the San Francisco-based investment consultant overseeing asset managers in Charles Schwabzzs managed account program, removed Chartwell Investment Partnerzzs large cap value equity product from the Schwab platform.

Callan noted that Chartwell had underperformed the median benchmark performance for nine out of 12 previous quarters and occupied the bottom decile for four of those nine quarters.

Was Callanzzs replacement of Chartwell typical of what happens behind the scenes among the 400 or so asset managers and sponsoring brokerage firms that constitute the separately managed account business? What, specifically, do analysts and consultants look for when studying managers? And, finally, do ongoing performance analysis and manager rotation lead to better results for clients?

The answers to many of these questions are counterintuitive; but then many things are not what they seem in the expanding world of separately managed accounts. Because of their tax advantages, investment flexibility and cachet, among other attributes (including the fact that they are not mutual funds, which currently seem down market and tainted to some investors), assets in managed account programs grew to $506 billion at the end of 2003, according to the Money Management Institute, the trade group for the managed account business. Thatzzs an increase of about 11 percent from the previous quarter and 29 percent above year-earlier levels. By comparison, assets in the $7 trillion-plus mutual fund industry, have grown by just 1.2 percent annually since 1999, according to Morningstar.

One of the attractions of investing through a separately managed account is the value that comes from having a group of professionals assess, monitor and select money managers. Instead of using stars or other rating devices to pick mutual fund managers, SMA investors rely on experts for the selection process. According to Eric Davison, a senior vice president at Callan, the firmzzs entire search and oversight analysis can be summarized by four Pzzs: people, philosophy, process and performance.

At Brinker Capital in King of Prussia, Penn., the operator of a managed account plat-form for approximately 1,700 advisors, chief investment officer Jim Harrington uses five Pzzs: people, philosophy, process, performance and passion. Harrington, who earlier managed pension investments for Sunoco, U.S. Airways and Crown Cork & Seal,

says passion may be hard to define, “but you know it when you see it.” For instance, when doing an on site visit to interview managers, Harrington may ask something like, “How much time do you have to talk?”

“If a portfolio manager answers, Izzve got all day to talk about stocks,zz thatzzs when I know he has passion,” Harrington says.

A closer look at the specific analyses beyond the top level Pzzs looks something like the table on page 70, which is the assessment process followed by analysts at SEI Investments on behalf of the 5,200 advisors on its platform.

Although the analyses performed by most sponsoring organizations are similar, there is some variance in the way results are reported. For example, Smith Barneyzzs man-

aged account platform uses a four-diamond system, with four diamonds being the best and one the worst. SEI Investments, on the other hand, slices and dices data to come up with a numerical rating that runs from 1 to 100.

Mike Hogan, who runs SEIzzs investment management unit, which oversees mutual funds and managed accounts, says managers gaining entree to SEIzzs platform must score between 80 percent and 90 percent. Still other platforms, such as those of Schwab and Brinker, use the equivalent of Wall Streetzzs buy-hold-sell model with a “recommended,” “watchlist” or “terminated” status for each manager.

The watchlist status can be problematic: If sponsors are looking for the best managers and getting rid of those that arenzzt, why is there a middle ground? Glen Regan, who oversees the due diligence of asset managers for Smith Barneyzzs managed account program – one of the largest on the Street – agrees.

“My feeling is that people come to us for our opinions,” he says. “So we generate explicit opinions that are presented, published and defended.” In Smith Barneyzzs four-diamond system, managers ranking three or higher are recommended and those with two or lower are not.

But other managed account professionals defend the watchlist status. For instance, Brinkerzzs Harrington says, “The general public does not understand why you would stay with a manager when they are trailing the benchmark. If you looked at the three-year performance of some of the very best managers in the world you might fire them. But if you looked at their five-year performance, you would have wished you kept them.” He adds that if you are going to hire a manager, “you must ride them for an entire investment cycle.”

Thatzzs the reason for the watchlists. As Callanzzs Davison point out, “Individual investors chased performance in mutual funds and found it was a zero-sum game.” The purpose of managed account oversight is to bring discipline to a process that individual investors and their advisors might not have on their own. And such discipline eschews hasty decisions. This discipline, with an emphasis on patience and a long-term outlook, very naturally leads one to wonder about the process that leads to the watchlisting or dismissal of a manager. And that leads right back to the first of the four Ps – people.

According to Jack Rabun, who studies managed account platforms for Cerulli Associates, “asset managers are now very aggressive about bringing on new talent. They are hiring teams wholesale away from their competitors.” But, he notes, every action produces an equal and opposite reaction. So as asset managers get poached, the assets they formerly managed come under the scrutiny of analysts who want to make sure the performance they thought they were buying into is still capable of being produced.

For instance, Callan placed Lazard Asset Managementzzs International Equity and Global Equity products on watchlist status in July of 2002 when “key product architects” Ron Saba, Jim Shore and Ray Vars left to form New York-based NorthRoad Capital Management. In its report, Callan said that it wanted to see if Lazard could maintain performance and consistency in investment philosophy and portfolio construction, as well as continue to motivate key decision makers. In November of 2003, having successfully fulfilled the majority of these evaluation points, Lazard was placed on full active status by Callan.

Dan Price, senior manager of research with Schwabzzs managed account programs, notes that if “the turnover in a product is low, the risk of staying with the manager and watching is low. There is uncertainty, but not enough risk to warrant termination.”

When Lehman Bothers acquired Neuberger Berman in October of 2003, for instance, Callan noted that “the deal has been structured appropriately to provide long-term incentives for key management professionals at Neuberger Berman. A back-loaded stock option program combined with non-compete contracts should ensure that integral members of the All Cap team remain in place…”

Just as analysts use subjective analysis to determine the risks of people changes at asset managers, they also apply a measure of subjectivity to the usually numbers-based game of performance measurement. Unfortunately, neither objectivity nor subjectivity – nor a combination of both – seems able to head off poor performance before it happens.

Says Smith Barneyzzs Regan, “We know that management styles come in and out of favor, so we try to create an understanding of what to expect from a managerzzs investment process. When we are evaluating performance after the fact, there are questions about how particular biases do against a benchmark.”

And in a similar vein from Callanzzs Davison: “Itzzs very difficult to evaluate an underperforming manager. Take large cap value managers for instance. They are not equal in their search for value. There is a low P/E approach, traditional value, and relative value. Therefore, the question becomes, how are they underperforming relative to the other large cap value managers?”

Whatzzs really difficult for brokers, however, is that individual investors rarely, if ever, think in these terms. According to Cameron Short, a senior vice president and financial consultant at Ryan Beck in Pittsburgh who has $140 million in managed accounts, “clients want to know how they did against the market.” But he stresses that unless you show clients their performance against that of their peers, “you are hanging yourself out to dry.”

Paul Hack, an advisor with Raymond James in Farmington Hills, Mich., who has more than 85 percent of his business in managed accounts, sees relative performance as an issue, too. He says that one of his greatest challenges over the past several years has been to explain to a client who has lost money that “they lost an appropriate amount, as opposed to an inappropriate amount.” He believes that changing managers, while disruptive, is an integral part of running a managed account practice because it serves to reinforce the process.

“When we replace managers, it lets the clients know we are doing our homework,” he says. “If you never change, they always wonder if we are watching the managers.”

Despite difficult choices that are part of the SMA process, historical performance suggests that the analysts conducting the due diligence on asset managers get it right most of the time. As the table above illustrates, separate managers have beat their mutual fund brethren each year over several periods.

So what happens to managers and the clients whose funds they manage when the managers are dropped?

Brinkerzzs Harrington says that information about the termination of a manager from a platform flows along an unofficial but highly efficient communications network consisting of trade press reports, emails and chatter at industry conferences.

Despite repeated attempts, none of the managers terminated from various SMA platforms recently wanted to talk to On Wall Street about the experience. But Cerullizzs Rabun offers some evidence that ejection begets trouble.

“Not that itzzs a secret; everyone is looking at the same stuff,” he says. “Performance deterioration, personnel movements, style and process changes – these are things that are not hard to spot, and so itzzs not unrealistic to believe that opinions would converge.”

The largest issue that most clients face when a manager is terminated concerns taxes. If there are large unrealized gains with a particular manager and funds are allocated to a different manager with a different basket of stocks, investors face the likelihood of a steep capital gains tax bill. This is a serious issue for a product that bills itself as more tax-sensitive than mutual funds.

Schwabzzs Price says that many advisors and brokers try to help their clients ease the process by transitioning them to managers where there is significant holdings overlap. While this would seem to be the equivalent of jumping from one defective frying pan into another, itzzs important to remember that itzzs not the stocks that are held, but rather when those holdings are sold that produces poor or superior returns.

Besides overlap, Price says, some managers will look at positions in the portfolio and rather than sell them out right, make a determination regarding the risk of holding onto them. If itzzs not that large, positions can be liquidated as losses are harvested.

Ultimately, says Callanzzs Davison, “there is no such thing as a perfect money manager,” a statement as obvious as it is profound. So despite the rigor of the analysis that goes into separate accounts, Schwabzzs Morris believes that success for financial advisors and their clients rests 75 percent with the art of selection and 25 percent with science.

Brokers and advisors would do well to see this as a glass half full. After all, mutual funds solved – and continue to solve – a myriad of problems individual investors face when trying to invest for the future. And managed accounts solved and continue to solve a series of challenges investors face with mutual funds. The next generation of managed accounts – probably the unified managed accounts that hold a broad array of asset types through a single platform – likely will solve some of the challenges that the current offering poses for advisors and investors today.