Separate Accounts Mired in Complexity

For the past three years, American Century Investment Management has been eyeing the separately managed account business, but it has not made a move.

"The managed-separate-account business right now, from a mutual-fund perspective, is an undesirable business to enter," says Harold Bradley, chief investment officer of U.S. Growth Equities Small/Mid Sectors, American Century Investment Management.

Brand-name mutual-fund companies - and large asset managers that manage separate accounts on the institutional side - are looking to enter the separate-account business, but very few have done so because of the technological complexity and high operating costs associated with managing thousands of individual accounts.

According to Bradley, sponsors are collecting 2 percent on their programs and paying managers 35 basis points.

Just a handful of mutual-fund companies have plunged into SMAs. They include: Phoenix, Dreyfus, AIM, Putnam, MFS and Eaton Vance, according to industry sources.

What's the Problem?

Asset managers must connect with a handful of brokerage firms that gather the assets and hire the money managers. The top brokerage firms - including Smith Barney, UBS and Merrill Lynch - are the major sponsors of separately managed accounts.

The operational complexity boils down to the brokerage houses having their own proprietary portfolio-accounting systems that hold the separate accounts. And, since most top asset managers participate in multiple SMA programs, they need to manually key this information into multiple systems.

"The managed-account business is a little cumbersome. You have to deal with everybody's separate system," says Larry Sinsimer, managing director of managed accounts at Eaton Vance.

To control multiple SMA programs, Eaton Vance uses the CheckFree Galaxy System as a central system for portfolio accounting, trading and account reconciliation. In early June, Eaton Vance said it would buy 80 percent of Parametric Portfolio Associates, a Seattle-based overlay manager with proprietary technology for managing separate accounts.

Galaxy is also a trading system and an account-reconciliation system. "You can produce your filing reports, securities held and percentages," says Sinsimer. "It seems to be the best out there."

"The problem is there's an additional expense. There's a per-tax-lot cost for every security you hold," he says. "If the industry could come up with a single-operating system, it would provide great economies of scale," says Sinsimer.

According to Christopher Davis, executive director of the Washington, D.C.-based Money Management Institute (MMI) - the trade association for the managed-account business - these programs have about $400 billion in assets under management, with about 100 money managers running most of the money for 10 major sponsor firms.

"The technology, or the connections between the sponsors and the managers, is just not efficient," says Davis. The industry has not evolved on an operations front as it has in some other areas, he contends. "It's as if two Campbell Soup cans are strung from sponsor to manager and another line has to be rung from sponsor B to manager A," he says. "There's too much manual work in terms of initial stages opening account and instructions. All that information flowing between managers and sponsors is so antiquated. It's being done by mail and faxes," notes Davis.

On top of that, asset managers are expected do all of their trading through the brokerage sponsor, so they need to enter their buy and sell decisions into the sponsor systems.

With SMA accounts, the broker keeps the client's assets. The asset managers just give the brokers the buy and sell orders, explains Mark Hoffman, chief executive officer of Upstream Technologies, developer of an investment-management platform that helps trade illiquid stocks. "If they're not great at executing some illiquid OTC stocks, the executions may not happen," says Hoffman.

One problem is that asset managers are not receiving real-time-status updates from the sponsors on orders, yet they need to keep up-to-date portfolios during the day, claims David Murphy, Upstream's executive vice president. "That doesn't happen," adds Hoffman, who claims (asset managers) get manual trade notifications, instead.

Standards Void

The problem is, "The technology to transmit those communications on a standard basis doesn't exist," says Vinnie Lepore, an adviser to the MMI's standards subcommittee, who previously developed the SMA business at ING Furman Selz. "The industry was crying out for standards."

About two years ago, MMI led an effort to develop a standard, tackling the most difficult area first - opening new accounts. "Asset managers have to make sure they have the right investment style, the right amount of assets, (especially) when you have thousands of Cusips and different assets." They also have to invest the assets on time. If the assets aren't invested, "then you're talking about significant liability," says Lepore.

Last July, the MMI published standards for new accounts, account terminations and contributions and withdrawals to new accounts. Next, it needed a platform for transmitting the standard. NSCC/DTCC "stood up to be a leader," says Lepore.

DTCC has been involved for the past year and a half and has helped organize the technology effort. The clearing corporation has already started transactions, based on version 1 standards, over the past two months, with a handful of sponsors and managers, says Lepore.

Now, through DTCC, MMI is talking about creating a central-messaging hub for new accounts and trading.

Sinsimer contends, "If there was a central operating system, it would be more efficient too. If you're in multiple programs, you end up executing multiple trades on the same security. You have to have a trade rotation in place, so that each client is getting a competitive execution," he says.

Status Quo vs. Alternatives

Meanwhile, 120 asset-management firms currently use the CheckFree APL system, because it has interfaces to all the sponsor's proprietary systems.

But some asset managers appear to be looking for alternative solutions.

Since 2001, American Century's Bradley has been experimenting with six different investment strategies on Upstream's platform, including international stocks.

With Upstream's software, Bradley can construct model portfolios that track a benchmark index or proprietary index, apply compliance rules to filter the model portfolio for restricted stocks, and adjust the risk to the needs of individual accounts.

The software incorporates an optimizer to manage the risk of each individual portfolio, and suggest trade ideas to address tax consequences. Then, Bradley takes the output from Upstream and keys it into Foliofn, a brokerage platform, to convert the model portfolios into separate accounts.

"Folio's model is: We'll do all the back office and brokerage for you, including performance-attribution tracking, and we'll put your model out to all your subscribers, and then we'll collect the price from them and pay you," says Bradley.

Bradley says he is working with Foliofn strictly for testing purposes. Through Foliofn, Bradley says he can push a button and replicate the model portfolio across all accounts, and then make it available to subscribers.

In testing these ideas, Bradley says he's convinced they would reduce the cost of operation in the SMA business. The next question, he says, is who is going to adopt Upstream's platform for cloning separate accounts and Foliofn's middle-office, back-office solution? But, Bradley concedes that the major brokerage firms with their high-cost-technology platforms still own the distribution model because they are the gateway and the intermediary.

Meanwhile, DTCC was supposed to go into production with the new MMI standard on July 1.

"I don't think there's any technology reason to miss this target," says the MMI's Lepore. "Part of the problems we're having now is the economic environment. If you go to firms and ask them to spend an extra dime on something that is not a core competency, they'll laugh in your face."

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio