Separately Managed Accounts (SMAs) are a widely used investment vehicle for endowments, retirement plans, foundations, and wealth managers. The popularity of SMAs is underscored by broad global institutional sponsorship and investor acceptance. As of 2015, more than $4.1 trillion was invested in SMAs in the U.S. SMAs have also enjoyed strong growth in European and Asian wealth markets.
But the benefits of SMAs, including lower expenses, tax efficiency, and client-specific portfolio customization, can be overshadowed by poor performance due to costs associated with implementing investment strategies. In a recent study, researchers analyzing SMA performance found three significant drivers of underperformance, which they broadly grouped into liquidity constraints, market impacts, and the “organizational stress” of managing too many accounts.
But underperformance due to account growth is neither inevitable nor unavoidable. This Insight discusses how the right technology choices help asset managers and sponsors effectively mitigate the drivers of underperformance and serve as a key differentiator for attracting new clients.
UNDERSTANDING SMAs
Available since the 1970s, SMAs were designed to help large investors meet specific financial and investment objectives. An SMA is a private, actively managed portfolio consisting of individual securities. As account minimums continue to drop, SMAs are increasingly accessible by the mass affluent market, and an attractive alternative to mutual funds. Their enduring appeal can be summarized by a few key benefits:
- Tax efficiency Since an SMA is composed of distinct securities with an individual cost basis, wealth managers can employ tax-loss harvesting and other strategies to reduce taxes. This allows investors to optimize individual after-tax investment returns.
- Customization SMA investors have broad discretion to customize or exclude individual securities recommended by the asset management model, allowing virtually any investment requirements to be met.
- Agility Clients can gain exposure to styles, and move in and out of sectors and asset classes more quickly to lower risk or capture new opportunities.
SMA UNDERPERFORMANCE RISKS
Investment underperformance can erase an SMA’s structural benefits, resulting in client terminations and lower fee revenue for asset managers.
In their paper titled “On Size Effects in Separate Accounts” researchers from the University of Augsburg analyzed 3,770 US-based Separate Accounts (SAs) over a 25-year sample period from 1991 to 2015 to understand the impact of size on performance. In this context, Separate Accounts include SMAs and Collective Investment Trusts. The researchers discovered three key drivers of underperformance as SAs grow in size:
- Liquidity constraints when implementing an investment strategy, especially for fixed income or emerging market securities
- Market impact, or adverse price movement in the time required to buy/sell the securities comprising a strategy
- The organizational stress incurred by servicing growing numbers of accounts, resulting in fewer holdings and less diversification
Given the continued strong growth of the wealth market these findings are important, in that they expose potential obstacles for sponsors and asset managers looking to grow accounts under management.
“A manager that has a complex infrastructure and a governance structure that is consistent with their process can monitor these things efficiently. We do see sophisticated organizations that can manage this effectively.”
Gregg Sommer
Principal and Head of Operational Risk Assessment
Mercer Sentinel
THE RIGHT TECHNOLOGY PROVIDES AN EFFECTIVE COUNTERWEIGHT
Growth in the number of portfolios managed in an SMA strategy should not result in underperformance from a lack of diversification, nor should it require an increase in staffing. The following sections discuss how Charles River’s Wealth Management Solution helps asset managers and sponsors eliminate operational bottlenecks and scale accounts without sacrificing performance.
ADDRESSING LIQUIDITY CONSTRAINTS
Ensuring proper diversification requires the ability to incorporate multiple asset classes in client portfolios. For institutional and high net worth clients, this might even include derivatives and commodities. But many asset classes, especially fixed income, have become increasingly illiquid due to market and regulatory changes. This poses multiple challenges for managers needing to buy and sell those assets for their SMAs.
Individual securities specified in an SMA may not be available to trade, requiring the firm to substitute securities that can replicate the strategy. For fixed income strategies, managers can also specify bond characteristics such as duration, maturity, and credit targets, rather than individual CUSIPs, to provide sponsors with sufficient latitude to source bonds that align with diversification goals. Unlike equities, many fixed income asset classes are still voice traded, requiring broker/dealers with the expertise to trade those instruments.
The Charles River Investment Management Solution is a multi-asset solution with specialized capabilities for trading Fixed Income and other OTC instruments. The Order and Execution Management System (OEMS) provides connectivity to multiple trading venues and dealers, ensuring unfettered access to global inventory. Aggregated quote and inventory data is displayed on a centralized platform, eliminating the need to access venue and broker specific interfaces. Support for generic, or characteristic-based securities, expedites a trader’s ability to find securities that meet the intent of the asset management model. The OEMS also maintains an extensive trade history on which counterparties have historically provided markets for a particular security, for both electronic and voice-traded CUSIPs. These capabilities support the efficient incorporation of fixed income securities in SMAs by eliminating much of the complexity associated with this asset class.
MINIMIZING MARKET IMPACT
Closely related to liquidity constraints is the problem of minimizing market impact when implementing an investment strategy across large numbers of accounts. It’s not uncommon to find SMA clients “owning” individual securities that may take up to 60 days to become invested at the manager’s discretion. This problem is obviously magnified when a strategy involves illiquid asset classes. An asset manager with a unique investment idea or market perspective has a limited time window to express that perspective at scale across their accounts.
Charles River provides asset managers with the requisite capabilities and scalability to implement strategies across large numbers of accounts on a timely basis. The ability to allocate trades across accounts and track performance on a time and price weighted basis is key, especially when trading in illiquid instruments that may take days or weeks to completely fill an order.
ENSURING DIVERSIFICATION BY REDUCING OPERATIONAL STRESS
Separate account management plays a key role in ensuring that SMAs align with client risk mandates, meet their tax and investment objectives, and maintain proper diversification across asset classes. Asset managers and subadvisors provide model portfolios to the SMA manager, who in turn makes account-level buy/sell decisions in client accounts. Essentially, this automates the application of portfolio rules that help wealth clients achieve specific investment goals at a reasonable cost. Once a client portfolio is in place, automated drift monitoring and periodic rebalancing ensure that the intended diversification targets are adhered to.
Charles River’s SMA management capabilities reduce operational stress by providing the scalability needed to meet the demanding requirements of high-volume sponsor firms with millions of accounts. Striking the proper balance between automation and personalization, and supporting exception-based workflows to identify accounts requiring attention allows managers to focus on portfolio diversification while adhering to individual customization requests.
KEEPING PACE WITH EXPANDING PLATFORM RELATIONSHIPS
As sponsors grow their asset manager network, managers need to streamline account on-boarding and daily account instruction communications with their affiliated sponsors. But the lack of an industry standard communication hub for exchanging information between managers and sponsors often creates significant operational inefficiencies.
Many firms are saddled with multiple systems and manual processes for communicating model updates, trades, allocations, and intra-day account instructions to sponsors. These systems must be individually managed and updated, and many utilize older, inflexible technology. Error-prone workflows and duplicative data entry required to stay in sync with sponsors consume significant amounts of staff time and increase operational costs.
Charles River’s Wealth Hub automates and streamlines communication between asset managers and their sponsors. This eliminates manager’s reliance on email and disparate legacy systems for uploading information separately into each sponsor’s platform. Firms access a single interface for all communications, where information can be securely received from, and distributed to, all applicable sponsors in a single click. Sponsors also benefit from a single system for quickly communicating client instructions back to the asset manager.
By reducing the operational overhead associated with manager/sponsor communications, Charles River facilitates broader distribution of asset management products. Intra-day notification of model changes and account instructions makes firms more responsive to client requests and changing market conditions, and frees up scarce resources for higher value activities.
DRIVING DIFFERENTIATION WITH PERFORMANCE
While researchers have identified that liquidity constraints, market impact and operational stress adversely affect SMA performance, the right technology can minimize and even eliminate these impacts as wealth mangers grow accounts under management and add new product offerings.
Brisk global growth in high net worth and affluent individuals is underpinning the continued popularity and growth of SMAs. A recent UBS study claimed that China produces a new billionaire on a weekly basis. Asset managers and sponsors realize they need technology, instrument coverage and processes in place to meet the idiosyncratic requirements of SMA management in global wealth markets. Firms that can support SMAs without sacrificing performance will increasingly attract sophisticated investors as the industry matures. Greater transparency into SMA performance is a welcome development, as it lets properly positioned firms differentiate their value proposition to the growing numbers of wealth clients.
