The sales pitch for separately managed accounts often goes something like this: "So you want to invest with the big boys but you've only got $100,000 to $200,000? With an SMA, you can invest right alongside world-class financial wizards, the managers who run funds with names like Rothschild and Mellon."

Sounds great, right? Well, maybe not so much.

"Over the past few years, we stopped using them," says Joseph W. Spada, managing director at Summit Financial Resources in Parsippany, N.J., which has $3 billion under management. "The cachet of getting better management, we didn't see that coming to fruition."

Spada is not alone. Total assets under management in SMAs have fallen in recent years from $700 billion in the second quarter of 2008 to $600 billion in the second quarter of this year, according to research firm Cerulli & Associates. To be sure, some of that decline is due to the overall market drop. But new investment vehicles called unified managed accounts also have begun to eat away at market share. And many planners say they now avoid SMAs entirely or, for reasons ranging from tax consequences to SMA managers' overly narrow mandates, use them only sparingly.

"Anyone with less than $1 million has no business being in a SMA. The costs are going to kill them," says Susan John, president of Financial Focus in Wolfeboro, N.H. John is also chair of the national board of the National Association of Professional Financial Advisors. "A lot of times, these things were oversold."


Whence SMAs?

First created in the 1970s, SMAs grew in popularity during the market boom of the 1990s. They give individual investors access to the investing strategies of large money managers. Those managers execute the same trades in outside client accounts that they use with their in-house clients.

A key difference - with real tax ramifications - between SMAs and mutual funds is this: SMA investors own shares directly, similar to hedge fund investors, while mutual fund investors own shares of the fund. Direct share ownership allows investors to harvest gains and losses annually for better control of their tax bills. They also have a better sense of what their capital gains pictures look like over the course of the year.

By contrast, mutual fund managers typically reconcile their taxes annually at the end of the year. Often this means that non-tax-sheltered investors who bought mutual funds in the last quarter find themselves facing the surprise of steep tax bills over which they have zero control.

In the pre-SMA world, clients typically needed at least $1 million and, more frequently, as much as $5 million to attract the attention of the largest and most successful money managers. Otherwise the cost of laboriously duplicating trades across accounts proved too high.

Then came increases in computer processing speeds and better software that enabled outfits like BlackRock, Legg Mason, PIMCO, and the big pension funds and foundations to begin tapping a new population of mass-market clients amid the innovation of SMAs. Managers could now make trades using computerized purchases that would populate those transactions throughout all of their client accounts.

In good markets, it's proved a popular way to go. When markets are on the way up, small investors hunt for managers with high returns just as assiduously as large investors do. But, in down markets, much of the distinction between managers vanishes along with any upside. Suddenly, financial advisors find themselves trying to explain to clients why it makes sense to pay 50 to 300 basis points in fees for actively managed accounts with flat or negative returns - not to mention the likely need for expensive accounting at the end of the tax year.

Furthermore, if clients want out of the market in a hurry, their SMAs can prevent them from acting quickly because trades must be made through outside money managers.

"Financial advisors need to prove their value-add," says Chris Davis, president of Washington, D.C.-based lobbying group Money Management Institute. Lately, he says, those using SMAs are finding that "it can be hard to get a good answer to the question, 'What have you done for me lately?' "


Who should invest?

Today, two-thirds of all SMAs are sold by wirehouses, which often charge the highest fees of up to 3%. Independent planners and RIAs use them more judiciously and typically charge less. It can make sense for higher- net-worth clients because of the tax freedom afforded by direct ownership of holdings.

Mutual fund investors, by contrast, have no such freedom in taxable accounts. But they are free from the trouble of accounting for profits and losses in each trade in a given mutual fund at the end of the year. Small SMA investors who fail to grasp this burden are in for a shock. Certified public accountants can charge as much as $10 per trade at tax time and fulminate at the extra work.

"Oh, it's terrible," says Sandra Field, founder and president of Asset Planning of Cypress, Calif., with $115 million in assets under management. "Not long ago I had new clients come in. A broker in a wirehouse had put them into an SMA. It was a taxable account at $300,000. They had just started it in December and they came to see me near the end of the next year. They had made no money and couldn't understand why. I looked at their statements and that's where I saw, 'Buy five shares of this, sell two shares of that, buy seven shares of that.' There was a minimum of 10 or 12 transactions per month. The CPAs went ballistic. Brokers make stupid mistakes putting taxable money into these things." Planners can avoid this problem entirely by putting only tax-deferred money into SMAs.


Bucking the national trend

At higher net worths of $1 million or above, however, the picture changes. Stashing taxable money in SMAs becomes the point. The freedom to sell or to buy individual holdings in order to generate losses or gains is an important tool in limiting taxes. Furthermore, management fees drop for larger sums of money, helping to offset annual tax accounting expenses.

This category of client is now driving SMA adoption. In fact, between the first and second quarter of 2011, despite an overall four-year downward trend, SMAs experienced a slight 2% increase in inflows that did not go unnoticed.

"People have been talking about the death of the SMA business," says David Lindenbaum, vice president for managed account solutions at Charles Schwab. "But we have a lot of high-net-worth investors with million-dollar account averages in our [SMAs]. The clients are bigger and we see them harvesting losses over the end of the year."

The same goes for Thornburg Investment Management in Santa Fe, N.M., one of the best-known SMA providers in the country with $82 billion in assets under management, including $8.8 billion in SMAs. Thornburg also estimates the average net worth of its 13,000 SMA holders at more than $1 million.

Bucking the national trend, both Thornburg and Schwab report that their SMA business grew rapidly this year, 15% for Thornburg and 27% for Schwab. Between 1998 and last year, Thornburg's SMA business averaged annual growth of 37% a year. The company attributes the drop in growth rate to the slowdown in the market and the fact that many investors are stockpiling cash.

In the second quarter of this year, Schwab bypassed Wells Fargo to become the firm with the largest SMA business at $56.2 billion in assets. This is likely due to the fact that in down markets, investors flee high fees - up to 3% - at wirehouses. "We do get a lot of accounts from wirehouses," Lindenbaum says.

Thornburg attributes the growth of its SMA business to a different factor entirely: the massive global outflow of capital from U.S. large-cap equities in favor of distant shores at a time when Thornburg has been focusing on foreign investments.

"There's been net inflow of capital into international equity," says Randy Dry, managing director of the institutional group at Thornburg. "That's our flagship strategy. We've seen a lot of growth that is coming from the investment strategy more than the vehicle."


Due Diligence and fees

For those planners who go the SMA route, due diligence is key. Field recommends understanding the mandate of an SMA manager. "You have to know the mandate," she says, "because an equity manager can't go to bonds. But maybe they could go to gold. You don't want someone whose mandate is, 'We will stay 100% invested.' Make sure there's the freedom to go to cash."

At her firm, John recently dropped two of the four SMAs she had used for clients who could afford them. "At the end of 2008, two of them started doing things that we thought were strange," she says, "and not what we understood to be in their investment policy."

Someone in John's office pays an annual in-person visit to the offices of the two remaining SMA managers the firm still uses. With $8 million in combined assets from her firm in one, she has negotiated sharply lower fees of 25 basis points to the SMA. For several layers of service, her SMA clients pay a total of 60 basis points. "The more assets we've been able to put with that manager, the better pricing we get for the whole group," John explains.

The more assets planners bring to an SMA, the more leverage those planners may also have in influencing the investment choices of the SMA money manager. Not all planners seek to exert influence, but some want the option.


Cash jockeying

One potential advantage of SMAs is that their managers aren't constrained by sudden cash outflows that bedevil mutual fund managers. These cash calls can interfere with a manager's ability to invest efficiently. Because SMAs are insulated from this "cash jockeying," as she calls it, John calculates that her two SMA managers make an extra percentage point to a percentage point and a half over mutual funds.

On the client side, she keeps suitable clients in her two remaining SMAs partly for the accounts' ability to provide reliable income for them. "Keep in mind who your clients are," she says. "I have a lot of retired clients. The most important thing to them is the regular paycheck."

After retiring, when they take distributions from their tax-deferred money in SMAs, that money is taxed as income, saving them the hassle of accounting for single trades. Overall, they don't always care about beating the index with an index fund, she says, but want the security of knowing they can count on a regular check.


Social screening

Another type of investor constitutionally suited to SMAs is anyone who requires transparent holdings. Investors who serve on boards, for example, may eschew owning particular stocks. Mormons and Jehovah's Witnesses often will not invest in so-called sin stocks, such as alcohol and tobacco companies. And some self-proclaimed socially responsible investors steer clear of big oil companies and known polluters for environmental reasons, or companies like Coca-Cola or McDonald's for health reasons.

Field estimates that 2% of her clients fit this mold. "They want to see the betterment of the world, but they want to make money," she says. "I had McDonald's in one of my socially responsible client's accounts. It pays a great dividend and it's growing." While McDonald's has added several healthier items to its menus, the client complained that the fast-food giant "is causing the obesity epidemic in children and didn't like the way the company treated chickens on their farms."

If you had an account directly with a wirehouse, Field says, your money manager would likely regard such a constriction as meddling and treat you like "a problem child." With an SMA you tell the manager, 'I should not own these things because of my lifestyle,'" Field says. "They put on the sin stock screen and make sure you are not invested in those holdings."


For whose benefit?

These and other advantages of SMAs don't much impress Brad Stark, a principal and co-founder of Mission Wealth in Santa Barbara, Calif., which manages about $600 million in assets for clients ranging in net worth from $1 million to $6 million. "Yes, you can see what you own," Stark says. "You don't take on the tax burden of a seasoned mutual fund. You can do more strategic tax harvesting. So there are more levers to pull. And there's an illusion of sophistication. But all this comes at higher fees. An SMA is an individually held or exposed mutual fund. That's all it is. So if I can buy an ETF for tons cheaper, then why am I buying an SMA?"

Stark thinks part of the reason is that ambitious money managers want people to buy their SMAs to create leverage. "They get scale by working directly with high-net-worth individuals," he says, "or they create these third-party assets."

Mission Wealth stopped buying SMAs for its clients seven years ago, only continuing to offer a single bond SMA, he says. Today, the company relies mainly on mutual funds and ETFs.

"ETFs have really destroyed the market for SMAs," Stark says. "From my standpoint, an SMA right now is a marketing gimmick."

Spada of Summit Financial would agree. Most of his clients' assets are invested in ETFs and he doesn't see that changing soon. "We only use mutual funds in less-efficient markets where we feel active managers can make a difference," he says.

Then again, active management even back at home can start looking alluring to clients once again in a fast-moving bull market. "If we go through another run-up and everybody puts their money in equities," investors may once again favor SMAs, Spadwa says.

But, run-up or not, he vowed, "We will be in index funds. They're more tax efficient and they're lower cost. Don't pay me to find you the best manager. Those managers will leave you at the altar. If there's a growth in SMAs going forward, it won't be us."


Ann Marsh is an author and journalist in Los Angeles who's written for the Los Angeles Times and Forbes magazine.