With all the focus given to new generations of multiple discipline portfolios (MDPs) in the past year, it would appear that the industry is experiencing a widening generation gap, even before it has fully explored the full potential of MDPs in their current incarnation.
Initially considered a transition product for moving clients from mutual funds to separate accounts, MDPs are proving to be a sophisticated wealth management solution, particularly for larger clients, such as high-net-worth individuals, trust accounts, endowments and some pension plans.
In 2004, MDPs are expected to grow to $49 billion in assets, or 20% of the managed account business, according to Financial Research Corp. This is not surprising given the broad appeal MDPs hold for program sponsors, financial advisers and clients alike. Offering access to a lineup of complementary investment strategies in a single portfolio, MDPs present many distinct advantages over a portfolio of stand-alone strategies: automatic rebalancing, enhanced tax management and simplified paperwork. In addition, many current generation MDPs feature allocation models that keep investors and advisers focused on long-term investment goals, instead of short-term performance.
Central to the MDP process is the overlay manager. Taking a comprehensive view of the account, the overlay manager is responsible for day-to-day account management, executing the investment recommendations of portfolio sub-advisors, conducting periodic rebalancing and managing trades for tax efficiency. While these are clear advantages for advisers and clients, the overlay manager is also a valuable resource for program sponsors.
As new generations of MDPs are conceived, the overlay manager continues to add significant value. Offering an in-depth understanding of specific investment strategies and how they work together, the overlay manager holds critical insights that can be helpful when a firm establishes its MDP program. This is especially true in the development of allocation models customized to individual sponsor firms, and in establishing new types of accounts, such as low-correlated income portfolios.
The Generation Gap
Like any good idea, the MDP concept is evolving to meet changing investment goals and new market opportunities. As a result, the industry has categorized MDPs by generations, with each generation representing an evolutionary change from its predecessor:
Generation I combines multiple strategies from a sponsor's proprietary managers.
Generation II integrates multiple disciplines from a single outside investment firm or complex and provides expanded access to investment expertise.
Generation III expands the idea to build a portfolio with unaffiliated managers.
Generation IV combines access to outside managers with dynamic allocation to give a financial adviser the flexibility to change portfolio risk to match changing client needs.
Generation V promises ultimate flexibility by combining separate account managers with alternative investment products in an integrated wealth management solution.
Weighing the Differences
Unfortunately, this generation system inherently implies newer generations are superior to previous generations, a notion that is not necessarily true. Generation III products are sometimes called "best of breed," though this can be something of a misnomer. While the idea of picking the best manager from each asset class sounds like MDP nirvana, in reality the "best" may choose not to participate because they are unwilling to share their investment decisions externally, or are unwilling to share already thin managed account fees with the overlay manager.
Generation IV MDPs introduce additional degrees of freedom by allowing for customized manager combinations and allocations. This approach offers the obvious benefit of flexibility, but it is not necessarily the ultimate MDP. Increased flexibility may come at the cost of more limited coordination between sleeves at the overlay manager level and re-opens the door for advisers and clients to chase hot performance.
A well-structured generation V MDP product can address a wide number of wealth management issues with a unified investment portfolio. While this approach allows advisers to integrate separate accounts, mutual funds, alternative investments and other vehicles into a single account, true generation V products are not yet available to most advisers. However, many advisers are already incorporating this concept into their MDP practice with a core and satellite approach that diversifies a core MDP portfolio with investments in non-correlated asset classes such as REITs or by seeking to boost alpha with alternative investments.
The evolution of MDPs is a healthy process for the managed account business, helping to push new ideas and new applications forward. Increasingly, MDPs are gaining acceptance throughout the industry both within the wirehouse and independent channels. But when evaluating MDP products, it is important to consider much more than just the generation it comes from. Many other factors, including the underlying strategies, overlay portfolio management capabilities and the appropriateness of the product for the adviser/client base it will serve, will be critical factors to the success of MDP programs.
Curtis L. Overway, CFA, is a senior vice president and portfolio manager with CDC IXIS Asset Management Advisers, whose expertise is separately managed accounts and overlay management for multiple discipline portfolios.
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