Exponential UMA and Model Growth: Perfect Storm of Risk Requires New Tech Solutions

According to the Money Management Institute (MMI), UMAs comprised some $123.7 billion of the $2.1 trillion total managed accounts market in the fourth quarter of 2010, up from $61.2 billion of the $1.7 trillion market in fourth quarter 2009. This represented a stunning 99.5% rate of growth from the prior year. Over the next few years, most industry observers expect UMA programs to largely supplant traditional separately managed account (SMA) programs, whose assets stood at $557.1 at the end of 2010.

Both UMA and SMA programs offer an investor the ability to create a customized investment plan that incorporates product disciplines of multiple money managers. UMAs go a step further by bringing together all the investor's holdings into a single investment account. The UMA structure allows for easier rebalancing of the managed products within the investor's account, and also provides enhanced opportunities for tax optimization of gains and losses. Assets in "rep as portfolio manager" (RAPM) programs grew by nearly 30% to $360.3 billion in 2010 according to MMI, driven in part by the migration of experienced financial advisors from wirehouse firms to independent practice, and also due to investor desire for flexibility in response to continued volatility in financial markets.

In this type of program, the advisor manages the client's account on a discretionary basis, and may rely in part on portfolio models provided by third party managers, to further customize the client's investment portfolio with additional investment products. As in the case with UMA programs, firms offering RAPM programs receive portfolio models and model updates from investment managers. The benefit of a more fluid rebalancing process in RAPM programs is similar to that of UMA, but RAPM also allows an advisor to act quickly in the event of market volatility, to move client assets to more stable investments. These factors and related trends, explored in the last edition of Peridrome Perspectives have ushered a change in how investment managers and broker-dealer sponsors are coupled when servicing the products. In traditional SMA programs, managers and sponsors are coupled at the investor account level: the manager maintains its own records of the investor's holdings and trades the account accordingly. In UMA and RAPM programs, however, the investment manager is responsible for supplying its portfolio model to the sponsor. The sponsor (or advisor) then combines it with portfolio models of other managers to trade the investor's account.

While beneficial to the end investor, this change in operations has created unexpected challenges for managers and sponsors. As assets in models programs continue to grow, operations professionals face a perfect storm of risk, as many firms are ill prepared to provide and receive portfolio models accurately and efficiently.

Model distribution is extraordinarily complex, requiring the seamless interaction of participants, starting with the asset manager responsible for developing and communicating a model strategy; followed by an overlay manager (or advisor), who implements the model strategy and changes via trade executions; and ultimately, the sponsoring firm that maintains clients' assets and performs the requisite account processing and reporting.

Managers sharing models across multiple relationships often must control when changes are released to comply with internal trade rotation practices. Because of the potential for portfolio changes to be released to distributors over multiple trading sessions, managers are also responsible for independently tracking the state of each distributor's version of a model, to account for differences in content based on when changes are approved and released. The growth of UMAs, and model distribution, in general, necessitate the accurate execution of time-critical tasks by trading desk and support staffs already assigned other sensitive functions. Having trading and middle office staff responsible for releasing model changes to distributors can represent significant operational risk, especially when those resources are burdened with manually formatting and communicating instructions for multiple recipients through a variety of channels such as email, file transfer, and web portals. Without centralized control and auditability of processing, a misstep may not be detected for days, weeks or months. In that time, market impact may be significant, resulting in one or more participant firms realizing losses to cover an error and make end investors whole.

"Models can be operationally burdensome due to the current myriad of systems and approaches," explains Jeff Strange, director of research for Cerulli Associates. "There is also no standardized automated feedback mechanism, for communicating back to the manager the completion of model changes and sponsor tracking to the model."

UMAs today represent only 6% of managed solutions assets, but if MMI's 2010 growth rates hold up, the UMA may replace the SMA as the dominant platform for third party managed solutions. A realignment of distribution from traditional SMA to models programs would result in an exponential increase in the sensitivity of each model change communication.

Fortunately, some solution providers are working diligently to develop new platforms while others are adapting their offerings to enable parties offering UMAs and model sharing to scale operations should asset growth and transaction volumes warrant. New capabilities include configuration options so participants can define their own processing rules, automate the review of model changes, flag exceptions, automate sign-offs, and customize displays.

As Strange concluded: "When there is a miscommunication between the investment manager and the overlay manager, the overlay manager can execute a trade erroneously or fail to immediately implement a model change. These kinds of miscommunication can occur when information is sent via fax, email or spreadsheet. With the rise in account volumes, new solutions for automating model communications could become critical."

About the Author: Gib Veconi, President of Peridrome Corporation, which recently introduced ModelStream, a Software as a Service (SaaS) solution designed to help investment managers and sponsors build, control and manage the workflow processes, communications and changes associated with the use of models.

Mr. Veconi is the former Director of Separately Managed Accounts Technology for Lord Abbett & Co., and a prior chair of the Money Management Institute's Operations and Communications Standards Committee. For a copy of Peridrome's 2011 survey report, "Managed Accounts Executive Outlook:Trends in Distribution, Operations and Technology" or more information on ModelStream, contact Peridrome at [email protected]