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Next-Generation SMAs In Search of Next-Generation Solutions

December 17, 2007
By Chris Kentouris

Unified managed accounts (UMAs) are moving to the forefront of the evolving separately managed accounts (SMA) marketplace, presenting the wealth management industry with new operational challenges that will require technological innovations to overcome.

As a bellwether for SMA sponsors, industry experts point to an announcement in February by Merrill Lynch & Co.--the largest sponsor for such accounts--that it was restructuring its program to accommodate UMAs.

Boston research firm Aite Group expects that UMAs, which now represent 3 percent, or $26.5 billion, of the estimated $884 billion in assets managed through tax-efficient SMAs and multi-style portfolios (MSPs), will climb to 8 percent, or $117 billion of $1.5 trillion, by 2011.

UMAs, an extension of MSPs, can include almost every asset in an investor's portfolio--single stocks, separate accounts, mutual funds and even hedge funds. However, limitations in trading and post-trade processing have required allocations in fixed-income and foreign equities to be conducted through exchange-traded funds, mutual funds and American Depositary Receipts rather than directly.

By grouping a client's assets together instead of breaking them up across multiple accounts, UMAs make it easier to keep track of capital gains and losses and improve post-tax returns. Such account customization for risk and tax management purposes allows financial advisers to better address the needs of their high-net-worth clients.

SMAs are more complicated than UMAs because they have "many different managers trading many small accounts on lots of different sponsored platforms," said Randy Bullard, EVP of business development for Placemark Investments in Dallas. "UMAs reduce the number of moving parts because there is a single overlay manager that handles most of the complexity," explained Bullard, who spoke at a recent Financial Research Associates conference on UMAs in New York.

Financial advisers come up with asset allocation models for their customers, but responsibility for implementing the models with either the adviser or the sponsor who selects the investment managers, and overlay managers who watch over the investment process.

Sponsors include Wall Street wirehouses Merrill Lynch, Morgan Stanley, Citigroup's Smith Barney, UBS and Wachovia Securities, which together hold an estimated 80 percent of the assets in the SMA market. Banks and independent broker-dealers are also scrambling to gain a foothold. SunTrust Banks of Florida, for example, recently decided to shift about $30 billion in trust assets over to a new UMA platform--a move that could lead to substantial growth in the bank channel if duplicated by competitors.

Firms such as Placemark and Seattle-based Parametric Portfolio Associates--majority-owned by Eaton Vance Corp.--serve as outsourced overlay managers for sponsors, treating each client's portfolio differently based on changing investment objectives and the performance, risk and tax characteristics of the client's assets. The overlay manager is able to consistently apply trading and other restrictions across an investor's entire account.

Management Styles

Overlay managers typically apply an active, passive or hybrid model, depending on the role they want to play in the trading process. In the active model, which is the most common, all money managers send their investment models to the overlay manager to be implemented in client accounts. In a passive approach, money managers are responsible for trading their part of the client's portfolio. A hybrid model, which is finding increased up-take, splits the trading function between the sponsor and money manager.

Regardless of the management style used, the overlay manager must do a significant amount of administrative work, necessitating frequent communications with underlying sleeve managers, who are responsible for creating macro-model portfolios to meet the risk and tax profile of the underlying investor as indicated by the financial adviser.

Active overlay managers rely on proprietary optimization software or third-party systems from providers such as CheckFree Investment Services and Wakefield, Mass.-based Vestmark Software, which focus on broker-dealer sponsors. The SunGard Advisor Technologies business of SunGard Data Systems, Smartleaf of Cambridge, Mass. and Upstream Technologies--purchased by CheckFree Corp. in May--are best known in the bank-administered overlay management area, where turnkey asset management program solutions (Tamps) are favored.

"Overlay management involves the standard operational process for maintaining a separately managed account--account opening and maintenance, reconciliation and performance generation--but overlay managers must do trade coordination among several managers, cash flows among investment styles within a single account, and performance verification at the sleeve level," said Cheryl Nash, SVP of CheckFree in Jersey City, N.J.

CheckFree acquired Boston-based Upstream to support its expansion into overlay portfolio management. It is incorporating Upstream's trading modules into its new EPL (Enhanced Portfolio Lifecycle) platform, which will replace the company's APL system.

Overlay managers use an array of sophisticated software tools to ensure that their investment results match the sleeve manager's. To reduce the potential for a discrepancy, or dispersion, the overlay manager must track all cash deposits, withdrawals and balances for each sleeve manager's account--and the underlying investor accounts--and rebalance the number of shares and cash.

An active overlay manager "is responsible for the account's overall asset allocation and must implement the securities-level changes, as directed by the money manager in each individual sleeve," said Rob Klapprodt, president of Vestmark, who spoke at the UMA conference. But in a passive model "the money manager is responsible for managing any dispersion within its sleeves which could occur to accommodate a client restriction or improve tax efficiency."

Layers Upon Layers

Adding to the complexity for overlay managers is that there can be more than one sleeve manager for each investment style and an array of investment strategies selected by end investors and their financial advisers. That's on top of the account activity taking place on any given day at a sponsor shop.

"There could be trading restrictions on a client's account and a multitude of accounts are being opened, closed and funded daily," said Vincent Lepore, product manager of SMAs and UMAs for HSBC Investments in New York, at the conference. "There could also be a discrepancy between whether a security should be bought or sold, depending on whether the overlay manager is looking for the highest possible return or reducing the tax impact."

HSBC, which uses a passive approach, is migrating its investment adviser clients from several overlay management firms onto a wealth management system hosted by Prudential Investments that the bank will run internally. Money managers will forward their trading models and communicate with HSBC through the portal.

PFPC Worldwide's AdvisorPort unit, which offers overlay management for bank and brokerage sponsors, uses a proprietary data hub as well as software from CheckFree for rebalancing. "We run a daily filter for dispersion and will rebalance the account based on whether it is a tax-managed or non-tax-managed account," said Jeremy Molish, director of trading for AdvisorPort. "The rebalancing does not take place randomly but depends on tax requirements, cash balances and trading thresholds. That means that we can deviate from the model of the sleeve manager."

Though interactions among overlay managers, sleeve managers and sponsors are often automated, proprietary communications standards open the process up to errors. "Most of the errors occur on the account management opening process rather than between the overlay manager and the sleeve managers," asserted Len Reinhart, managing director of managed account solutions for Bank of New York Mellon Corp.'s Pershing subsidiary. "When we receive information from financial advisers on their clients we are able to electronically match up the risk portfolio of the client with the investment style selected. If there is a mismatch, we immediately notify the financial adviser."

An industrywide committee led by the Money Management Institute (MMI), which includes Depository Trust & Clearing Corp. (DTCC) and leading sponsors, has created standardized messages for a new DTCC SMA service that will act as a centralized hub for plan sponsors and fund managers. Officials at DTCC would not say when the hub will be available but noted that account opening and maintenance messages are being pilot-tested by Citi's Smith Barney and Global Transaction Services units.

The MMI is also creating a subcommittee to standardize the flow of data between sleeve managers and overlay managers. While overlay managers and sleeve managers typically communicate electronically, they do so via e-mail and spreadsheets based on formats set by the overlay manager. Such a process requires due diligence on the part of both parties. If PFPC doesn't hear from its sleeve managers within a certain period, "we proactively reach out and contact them to see if the e-mail has been missed," said Molish.

For active overlay managers, communicating trade instructions is also critical. After figuring out how much it should buy of each security, Placemark sends customized file formats to FIX Flyer's online service for trading and allocation management, ultimately reducing the trader's workload.

Household Accounts

Unified managed household (UMH) accounts could take the UMA concept one step further by focusing on a client's total assets across multiple financial services firms, but there are obstacles to overcome before UMHs catch on. Overlay managers would need to receive detailed, accurate and timely information from, in some cases, several custodians and wealth management firms.

"Custodians have been distributing data to wealth managers that own the client account, but they would need to change their systems and implement additional authorization processes in order to allow the data to flow to other wealth managers as well," said Alois Pirker, a senior analyst with Aite Group. "There is currently little incentive for custodians to do that."

For wealth managers, implementing a UMH strategy is made problematic by the number of products they need to meet adviser demands--retirement planning, proposal generation and portfolio construction tools. Because the systems do not interface with each other, financial advisers have to rekey information several times when advising a single client. To obtain a holistic, up-to-date view of all a client's products, advisers would have to query several systems.

So far, according to Pirker, no single platform is able to service the spectrum of UMH requirements, but SunGard's WealthStation comes closest. The application makes use of a host of SunGard solutions for financial planning, portfolio construction and trust-accounting and, by integrating with Smartleaf's Portfolio Manager, provides overlay management capabilities. Vestmark recently introduced a module for household-level portfolio construction, analysis and performance measurement, now in production at Robert W. Baird & Co.

"As with all platform projects, the difficult part of the UMH implementation project will be to assemble all necessary solutions into one seamlessly integrated platform--a problem with which many wealth management firms are very familiar," said Pirker.