Much has been said about the growth of the separately managed account industry - both in terms of the growth this market segment has experienced in the past few years and also in terms of the anticipated growth that many analysts predict. Once distribution channels become optimized to handle the expected growth of SMA money, it is widely predicted that SMAs will replace mutual funds as the investment product of choice for individual investors.

At the same time, the separate account industry is facing a situation whose root causes can be found in the way the industry is structured and, ultimately, the lack of advances in the portfolio software used to manage separate accounts. The issue at hand is the ability of money managers to become compliant with the performance presentation standards (PPS) of the Association for Investment Management & Research (AIMR) of Charlottesville, Va.

As the separate account industry and its participants take steps to redefine this segment of the market to realize the growth potential that analysts are predicting, the shortcomings of the technology used by many firms must be addressed. The history of American separate accounts also serves as an educational case study for the developing wrap markets in Europe, Asia and the rest of the world.

In 2002, AIMR released a guidance statement on "wrap fee performance." Largely, the purpose of this guidance was to clarify the meaning of the text of the AIMR performance standards as they applied to wrap fees. However, the guidance also distilled the critical components of the standards that are meant to apply to separate accounts, both institutional and retail.

Of the issues covered in the guidance statement, the single statement that presents the largest impediment to manager compliance is the very first statement of the standards: "All data and information necessary to support a firm's performance presentation and to perform the required calculations must be captured and maintained."

Daily Valuations

The implication of this statement is that a money management firm that wants to be compliant with the standards must have a complete transaction and position history for the period of time covered by its performance presentation. Without the data to substantiate the returns presented, the presentation cannot be verified as compliant.

The current requirement for institutional or individual accounts is for monthly valuations of accounts. The standards include, however, a gradual increase in the accuracy of the posted rate of return data. Daily valuations will be required beginning Jan. 1, 2005. This increases the data burden on the management firm significantly; instead of monthly positions and daily transactions, the requirement becomes daily positions and daily transactions.

In order to fully understand the implications of these data requirements, we must look at the roles of the participants in the separate account industry: the individual investor the sponsor firm, which sells the managed account product to the individual investor; the money management firm, who is hired by the sponsor firm to make investment decisions; and the adviser or consultant, usually a representative of the sponsor firm that is the liaison with the investor.

The sponsor firm, in addition to hiring managers, administers the separate account program. This includes facilitating trading and settlement, client reporting and performance measurement, and providing the platform software used by the money managers that participate in their separate account program. As a result, the sponsor firm maintains the position and transaction information on its portfolio accounting software.

This presents a critical problem to money management firms; the software systems typically used by sponsor firms are older systems developed by the sponsor firm itself or by a third-party vendor that has not adapted its system to take advantage of newer technologies. Managers need the ability to easily extract account position and transaction information from the sponsor systems. The technologies that would enable this include relational databases, file extracts in easy to process formats (preferably XML - extensible markup language), plus intuitive Web-enabled user-interfaces that would enable money managers and advisers to extract the data without requiring the assistance of highly technical personnel. Because the systems utilized by most sponsors today do not employ these technologies, it is impossible for many sponsors to allow managers to extract data.

Additional Complications

There are additional complications to the situation. Sponsor firms currently provide performance reporting to the investors themselves, so the needs of the investor are met from the sponsor's viewpoint. There is little incentive for the sponsor to provide a data extract of positions and transactions for the manager. If they were to do so, they would assume an additional liability for its correctness.

A few sponsors do utilize systems that can enable managers to extract position and transaction data. But even because most managers participate in separate account programs with several sponsor firms, it is highly unlikely that all of their sponsor partners have the technology to share performance data with them.

In addition, since sponsors use different portfolio accounting software, the extract formats may differ, and there is a burden on the manager to consolidate the multiple feeds into one coherent set of data.

AIMR is suggesting that if a manager cannot extract the data from its sponsor, it should then "shadow" the sponsor firm's records. That is to say that the money management firm must effectively duplicate the transaction history maintained by the sponsor by keeping its own records. The cost of this would be prohibitively high for most money management firms because the process of keeping duplicate records would require error-prone manual data entry of transactions in many cases, and then there would be an additional cost of reconciliation with the sponsor's records. Add to this the need for the manager to have its own performance measurement system. All told, shadow accounting does not seem to be an attractive option for the money management firm.

AIMR's performance standards were intended to go into effect on July 1. During an open comment period, the Money Management Institute, the Washington trade group for separate accounts, authored a strong response to the AIMR proposed standards. MMI went to great lengths to describe why the separate account industry was different from the institutional account model and why different considerations must be made. MMI indicated that the wrap industry could not meet the requirements in the standards within the requested timeframe largely due to technology considerations. It gave detailed alternatives for the separate account managers to be able to achieve compliance by using disclosures and providing supplemental information in a variety of scenarios.

In addition, the industry took issue with another AIMR requirement that would have required money managers, not the selling brokers, to take responsibility for all marketing materials. The industry argued that this would be an undue onus since brokers and advisers primarily handle sales and often customize these products.

AIMR has since postponed the effective date of the guidance statement pending further review and is currently working with the separate account industry to make changes to the standards that will allow the industry to have a shot at achieving compliance. AIMR is now hoping to set an agenda for revising the guidelines by the end of the month.

At the same time, industry awareness about the performance standards has increased considerably and the subject of AIMR compliance has been on the agenda at virtually every seminar and conference held on separate account issues over the past two years.

So what changes must be done to have a workable solution to comply with AIMR's performance guidelines for the separate account industry?

Possible Solutions

Each of the participants in the separate account industry can do something to facilitate managers being able to provide AIMR-compliant presentations. MMI has a group devoted to developing data standards to facilitate straight-through processing (STP) for data passed between money managers and sponsors. Most of the initial discussions have been centered around providing a standard means for the creation of new accounts and for trading, but a logical next step is the development of a data format and a minimum standard for passing position, transaction information and performance data from the sponsor to the manager firm. Ideally, AIMR should be consulted on any data standard for performance-related data to ensure that MMI's data standards support AIMR's initiatives. In the past, AIMR has stayed away from specifying data elements and components of performance calculations down to the level that the MMI data standards should address. In recent years, however, the AIMR's performance standards have been reshaped as more of a calculation and performance standard. Given the requirement for the separate account manager to have access to all data involved, it makes sense for there to be a specified minimum standard for that data.

It may also make sense for AIMR to make an exception for the separate account industry with respect to the issue of valuations on any cash flow date as of Jan. 1, 2005. It will likely take more than extracts to be created and tested by the industry, in order to have a successful implementation of the standards. At the same time, sponsor firms should be open to looking at portfolio accounting systems that utilize newer technologies in order to facilitate the needs of managers.

As the separate account industry grows and reshapes itself, there may be value in the sponsor firm providing managers with this data. New entrants in the distribution of separate accounts include many types of investment companies, including investment banks, mutual fund companies, that utilize software that provide easy extracts of data. Money managers should also examine current technologies in standalone performance measurement systems that can significantly lower the cost of shadow accounting.

In summary, it is likely that AIMR's performance standards will be a more viable option for the managed account industry in the future, although somewhat later than the July 1 date initially set by AIMR for having a standard in place. The initial draft of the AIMR guidance did start the necessary discussion within the industry to generate awareness and create the environment necessary for change, and as AIMR works with the industry and MMI in particular, the chances of arriving at an achievable standard are increased significantly. From there, it will be up to the participants in the industry to make the change a reality.

John D. Simpson is director of application research at Integrated Decision Systems, a software firm that develops portfolio management systems for managed accounts and multi-manager portfolios.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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