Separately managed accounts: A mutual fund alternative

The investment management world is divided into retail and institutional investors. Products designed for middle-income individual investors, such as the retail classes of mutual funds, have modest initial investment requirements. Managed strategies for institutions have imposing minimum investment requirements of $25 million or more.

Between these ends of the spectrum, however, is the growing universe of separately managed accounts (SMAs) targeted toward wealthy (but not necessarily ultra-wealthy) individual investors. Whether you refer to them as "individually managed accounts" or "separately managed accounts," managed accounts have gone mainstream. This article examines the world of SMAs and what investors – or their financial advisors – should keep in mind when considering such an investment.

An SMA is a portfolio of assets managed by a professional investment firm. In the United States, the vast majority of such firms are called registered investment advisors and operate under the regulatory auspices of the Investment Advisors Act of 1940 and the purview of the U.S. Securities and Exchange Commission (SEC). One or more portfolio managers are responsible for day-to-day investment decisions, supported by a team of analysts, operations and administrative staff.

SMAs differ from pooled vehicles like mutual funds in that each portfolio is unique to a single account (hence the name). In other words, if you set up a separate account with Money Manager X, then Manager X has the discretion to make decisions for this account that may be different from decisions made for other accounts. Mutual funds cannot offer, due to their structure as investments shared by a group of investors, the benefit of customized portfolio management. Separate accounts overcome this barrier.

Say, for example, that a manager oversees a diversified core equity strategy including 20 stocks. The manager decides to launch a mutual fund investing in these stocks as well as a separately managed account offering. Assume that at the outset, the manager chooses the same investments and the same weights for both the mutual fund and the SMA. From a client's perspective, the beneficial interests in either vehicle are identical at the outset, but the statements will look different. For the mutual fund client, the position will show up as a single-line entry bearing the mutual fund ticker – most likely a five-letter acronym ending in "X." The value will be the net asset value at the close of business on the statement's effective date. The SMA investor's statement, however, will list each of the equity positions and values separately, and the total value of the account will be the aggregate value of each of the positions.

From this point, the investments will begin to diverge. Decisions the manager makes for the mutual fund – including the timing for buying and selling shares, dividend reinvestment and distributions – will affect all fund investors in the same way. For SMAs, however, decisions are made at the account level and will therefore vary from one investor to another. (For related insight, see "Wrap It Up: The Terms and Benefits of Managed Money")

The high level of customization is one of the main selling points for SMAs, particularly when it comes to individual taxable accounts. Portfolio transactions have expense and tax implications. With managed accounts, investors may feel like they have a greater degree of control over these decisions, and that they are more closely attuned to the objectives and constraints set forth in the investment policy statement.

So what is the price of entry for this extra level of customized attention? Given technological advances, money-management firms have been able to significantly reduce their minimum investment requirements to well below the traditional $1 million mark. But there is still no single answer for the several thousand managers that make up the SMA universe. As a general rule of thumb, the price of entry starts at $100,000. SMAs targeted to high-net-worth retail investors tend to set account minimum balances between $100,000 and $5 million. For strategies designed for institutional managers, minimum account sizes may range from $10 million to $100 million.

For style-based investors who seek exposure to several different investment styles (e.g., large-cap value, small-cap growth) the price of entry goes up, as there will be a separate SMA, and a separate account minimum, for each style chosen. For example, an investor seeking style-pure exposure in the four corners of the style box — large cap, small cap, value and growth — might need to have at least $400,000 available to implement an SMA-based strategy. Other investors may prefer an all-cap blend (or core) approach that could be accessed through a single manager.

In addition, investors can impose restrictions on how the account is managed. For example, a client might not want to invest in alcohol or tobacco companies or they may wish to invest only in companies that are committed to some greater good, such as helping the environment. Separately-managed accounts are ultimately designed to provide individual investors with the kind of personalized money management that was formerly reserved for institutions and corporate clients.

The ability to have individual cost basis on the securities in your portfolio is the key to those benefits. To understand the significance, consider the nature of the mutual fund. In its most basic form, a mutual fund is a company that invests in other companies by purchasing the stocks and bonds issued by those companies. When you purchase shares of a mutual fund, you share ownership of the underlying securities with all of the other investors in the fund. You do not have individual cost basis on those securities. Consider the following example:

ACME Mutual Fund holds shares of two companies: Company 1 and Company 2. You purchase 100 shares of ACME Mutual Fund. While you own those 100 shares of ACME Mutual Fund, you do not own any shares of Company 1 or Company 2. Those shares are owned by the ACME Mutual Fund company. Since you are an investor in the ACME Mutual Fund company, you can buy or sell shares in the ACME Mutual Fund company, but you have no ability to control Acme's decision to buy or sell shares in Company 1 or Company 2. In a separately managed account, you do own those shares. If a separate account portfolio includes shares of Company 1 and Company 2, the money manager purchases shares in each of those companies on your behalf. 

To avoid the "mutual" nature of mutual funds, you could choose to purchase individual stocks and bonds to build your own portfolio, but that is a time-consuming proposition and denies you the benefit of professional portfolio management, which is the primary reason most investors put their money in mutual funds. To obtain the benefits of professional portfolio management without the hindrance of mutual ownership of the underlying securities, an increasing number of investors are turning toward separate accounts.

One of the most significant benefits of separate accounts involves tax gain/loss harvesting, which is a technique for minimizing capital gains tax liability through the selective realization of gains and losses in your separate account portfolio. Consider, for example, a separate account portfolio in which two securities have been purchased at similar prices. Over time, one of the securities has doubled in value while the other has fallen by half.

By instructing the money manager to sell both securities, the gains generated by the security that has doubled in value are offset by the losses in the other security, eliminating any capital-gains tax liability. The proceeds from the sale can be reinvested, maintaining the balance in your account. In a similar fashion, if you sold some real estate, art or other investments at a gain, but have unrealized losses in your separate account, you could realize the losses and use them to offset the gains from the sale of your other investments.

Another tax benefit of individual cost basis is the lack of embedded capital gains. Again, a comparison to mutual funds demonstrates this issue. Mutual funds must pay out all capital gains once per year. Since mutual funds are "mutual," all investors share the tax liability on the gains. So, for example, if the fund doubled in value from January through November, investors purchasing into the fund in December did not get the benefit of any of those gains, but they do inherit the tax liability because the gains are embedded in the portfolio. Separate account investors, thanks to individual cost basis on the underlying securities, would not be liable for capital gains generated prior to the day they invested in the portfolio.

One of the difficulties inherent in making an apples-to-apples comparison among investment offerings is that fee structures vary. This is even trickier for SMAs than for mutual funds, for reasons explained below.

Mutual fund fees are fairly straightforward. The key number is the net expense ratio, including the management fee (for the professional services of the team that runs the fund), miscellaneous ancillary expenses and a distribution charge called a 12(b)1 fee for certain eligible funds. Many funds also have different types of sales charges. Funds are required to disclose this information in their prospectuses and show explicitly how the fund expenses and sales charges would affect hypothetical returns over different holding periods. Investors can easily obtain a fund prospectus from the fund's parent company, either online or through the mail.

A prospectus is not issued for a separate account. Managers list their basic fee structures in a regulatory filing called a Form ADV Part 2. An investor can obtain this document by contacting the manager, but they tend not to be as widely available through unrestricted online downloads as mutual fund prospectuses. Moreover, the published fee schedule in the ADV Part 2 is not necessarily firm – it is subject to negotiation between the investor (or the investor's financial advisor) and the money manager. Often, it is not a single fee but a scale in which the fee (expressed as a percentage of assets under management) decreases as the asset volume (the amount invested) increases.

Because SMAs do not issue registered prospectuses, investors or their advisors need to rely on other sources for investigating and evaluating the manager. In investor-speak, this is referred to as due diligence. Comprehensive due diligence will elicit sufficiently detailed information regarding all of the following areas:

A manager should be prepared to share performance data (annual and preferably quarterly returns achieved) since the inception of the strategy. The information is contained in a composite – a table showing aggregate performance for all fee-paying accounts in that strategy. A good question to ask here is whether the composite complies with the Global Investment Performance Standards set by the CFA Institute and whether a competent third-party auditor has provided a letter affirming compliance with the standards.

Each manager has a unique investment philosophy and method of applying that philosophy to an investment approach. You will want to know whether the manager has a more active or passive style, a top-down or bottom-up approach, how he or she manages alpha and beta risk, the strategy's performance benchmark and other similar information.

Find out who makes the decisions and how they are implemented; the roles and responsibilities of portfolio managers, analysts, support staff and others; who's on the investment committee; and how often it meets. Then sell discipline and other key aspects of the process.

Some managers have extensive in-house trading platforms, while others outsource all non-core functions to third-party providers like Schwab or Fidelity. You also need to understand transaction expenses and how they can affect your bottom line. Another useful area of information here is client and account services. Among other things, here you can find out about net client activity – how many new clients did the firm originate and how many left over a defined time period? What were the circumstances surrounding those who left?

How the firm is organized and how it pays its professionals – especially the managers whose reputations and track records are the big draw – are extremely important aspects of the investment. Understand the calculations behind incentive compensation. Are the manager's incentives aligned with those of the investor? This is an essential feature.

Red flags include prominent infractions with the SEC or other regulatory bodies, fines or penalties levied and lawsuits or other adverse legal situations. The SEC considers separate account managers to be investment advisors subject to the provisions of the Investment Advisors Act of 1940.

Much of this information can be obtained from the manager's Form ADV Parts 1 and 2 (Part 2 includes more details on strategy, approach, and fees as well as biographical information on the principal team members). Performance data should be available directly from the manager, either online or through personal contact with a management representative. The representative should also be able to coordinate phone or in-person meetings with key team members and direct your questions regarding compliance and other issues to the appropriate personnel.

Given the account minimums, separately managed accounts are not for every investor. If you have the means, they can be a useful alternative to mutual funds or other pooled vehicles and more closely align with your own specific return objectives, risk tolerance and special circumstances. To maximize the benefits separate accounts offer, most investors work with a professional investment advisor. The advisor assists with asset-allocation decisions and money-manager selection, as well as coordinates portfolio customization and gain/loss harvesting.