David R. Evanson

Investment News, Spring, 2004

Separately managed accounts are one of the few bright spots in the asset management business. To wit, while mutual fund assets have contracted 3% annually since 1999, SMAs have grown by almost 7% annually numbering 2 million accounts with $443 billion, according to the Money Management Institute. Further, MMI has an over the top estimate of 12.5 million accounts with $2.1 trillion [italicize trillion] by 2011.

For many asset managers, grabbing a piece of this pie has been a panacea. The trucks literally pulled up and began unloading the money without any marketing to retail investors. For others however, the value of SMA programs have been questionable. The intensity of the relationship with sponsors, and low margins have got some managers wondering if they might have been better off not getting what they wished for.

Many asset managers, says Mark Pennington who runs private advisory services for Lord Abbett which manages separate accounts for 8 sponsors, are unprepared for the ongoing demands – both time and costs – of the due diligence. “It is time consuming and we need to prepare for it, and it takes time away from other things”. Remember, the selling point for sponsors is the oversight of managers. Accordingly, they acquit themselves with the kind of scrutiny that would make an FBI agent proud.

Pennington says that “Because the sponsors can literally see right into accounts, it means they come in for their regular due diligence meetings armed to the teeth with penetrating questions.” Pennington, a champion of the process because of the benefits it bestows on the individual investor, says that “Managers who have never had to do this will find learning how to articulate what they are doing to standards if institutional scrutiny will find a very steep learning curve.” And keep in mind, managers really making a go of the separate account business seek multiple platforms and face multiple inquisitions.

No one ever quit the SMA business because of the oversight. They have however quit because the oversight, combined with narrowing margins has, made the entire proposition less tenable. For instance, State Street Advisors, made a well thought out foray into the business, and after 4 years, made a well though out exit. According to spokesperson Alyson Riley, “What we learned is the separate account business is expensive to be in, and requires a great deal of scale.”

Marketing and operating costs are responsible for the thinning margins says Mike Evans at Boston-based Financial Research Corporation.

For SMA neophytes, marketing costs might seem to be a misnomer. Isn’t the point of getting on an SMA platform to reduce the time and energy associated with gathering assets? Perhaps, but because there truly is no free lunch, a whole new marketing dynamic emerges in the SMA business. First says Evans, “Money managers on an SMA platform need marketing people out in the field because they are support mechanism for the brokers or RIAs, or planners generating the assets.”

More importantly however, if a broker lands a big piece of business, and there is a large allocation to say, large cap value, there is almost always an expensive and nerve racking bake off of the large cap value managers on the sponsor’s platform.

And the marketing muscle is not cheap. According to FRC’s most recent study on distribution trends, the base salary, commission and bonus for external marketers totaled about $248,000 in 2002, and on average, each manager had about for marketers on staff.

In addition, operation eat up 7 to 15 basis points of the managers fee, which right now hover between 40 and 45 basis points, somewhat less for fixed income. Achieving and maintaining connectivity with a sponsors’ platform is significant particularly, if a manager is on several platforms. “Unlike the clearing and custody business,” says Evans, “there is no central platform and the operating personnel spend a lot of time simply logging out of one system and into another.”

So what’s the bottom line? About a 20% margin on the 40 to 45 basis point management fee. While a double digit operating margin is pretty good, it needs to be considered against the staying power required to get there.

“Based on the models we’ve run” says Jack Rabun, a senior analyst with Cerulli Associates in Boston, “Breakeven will occur at about $1.2 billion, which starting from scratch, might take about four years.” Worth the price perhaps, but a long time to second guess whether or not getting in the business was the right decision in the first place.