After almost three years, it was over. This past December, Callan Associates, a San Francisco-based investment consultant overseeing asset managers in Charles Schwab's managed account program, removed Chartwell Investment Partner's large-cap value equity product from the Schwab platform. Callan noted that Chartwell had underperformed the median benchmark performance for nine out of 12 previous quarters and occupied the bottom decile for four of those nine quarters.

Was Callan's replacement of Chartwell typical of what happens behind the scenes among the 400 or so asset managers and sponsoring brokerage firms that constitute the separately managed account business? What, specifically, do analysts and consultants look for when studying managers? And, finally, do ongoing performance analysis and manager rotation lead to better results for clients?

The answers to many of these questions are counterintuitive, but then, many things are not what they seem in the expanding world of separately managed accounts.

One of the attractions of investing through a separately managed account is the value that comes from having a group of professionals assess, monitor and select money managers. Instead of using stars or other rating devices to pick mutual fund managers, SMA investors rely on experts for the selection process. According to Eric Davison, a senior vice president at Callan, the firm's entire search and oversight analysis can be summarized by four P's: people, philosophy, process and performance.

At Brinker Capital in King of Prussia, Pa., the operator of a managed account platform for approximately 1,700 advisers, chief investment officer Jim Harrington uses five P's: people, philosophy, process, performance and passion. Harrington, who earlier managed pension investments for Sunoco, U.S. Airways and Crown Cork & Seal, admitted passion may be hard to define, "but you know it when you see it." For instance, when doing an on-site visit to interview managers, if Harrington asks a portfolio manager how much time they have to talk, and they respond they have all day, that's when Harrington gets the sense they have passion.

Although the analyses performed by most sponsoring organizations are similar, there is some variance in the way they tally the results. For example, Smith Barney's managed account platform uses a four-diamond system, with four diamonds being the best and one the worst. SEI Investments, on the other hand, slices and dices data to come up with a numerical rating that runs from one to 100. Mike Hogan, who runs SEI's investment management unit, which includes mutual funds and managed accounts, said managers gaining entry to SEI's platform must score between 80% and 90%. Still other platforms, such as those of Schwab and Brinker, use the equivalent of Wall Street's buy-hold-sell model with a "recommended," "watchlist" or "terminated" status for each manager.

The watchlist status can be problematic: If sponsors are looking for the best managers and getting rid of those that aren't, why is there a middle ground? Glen Regan, who oversees the due diligence of asset managers for Smith Barney's managed account program, thinks it's a bad idea to retain a manager in the middle group. In Smith Barney's four-diamond system, he noted, managers ranking three or higher are recommended and those with two or lower are not.

But other managed account professionals defend the watchlist status. For instance, Brinker's Harrington said, "The general public does not understand why you would stay with a manager when they are trailing the benchmark. If you looked at the three-year performance of some of the very best managers in the world, you might fire them. But if you looked at their five-year performance, you would have wished you kept them." When looking at managers, Harrington said, "you must ride them for an entire investment cycle."

That's the reason for the watchlists. As Callan's Davison pointed out, "Individual investors chased performance in mutual funds and found it was a zero-sum game." The purpose of managed account oversight is to bring discipline to a process that individual investors and their advisers might not have on their own. And such discipline eschews hasty decisions. This discipline, with an emphasis on patience and a long-term outlook, very naturally leads one to wonder about the process that leads to the watchlisting or dismissal of a manager. And that leads right back to the first of the four P's: people.

According to Jack Rabun, who studies managed account platforms for Cerulli Associates, "asset managers are now very aggressive about bringing on new talent. They are hiring teams wholesale away from their competitors." And as asset managers get poached, the assets they formerly managed come under the scrutiny of analysts who want to make sure the performance they thought they were buying into is still capable of being produced.

For instance, Callan placed Lazard Asset Management's International Equity and Global Equity products on watchlist status in July 2002 when "key product architects" Ron Saba, Jim Shore and Ray Vars left to form New York-based NorthRoad Capital Management. In its report, Callan said that it wanted to see if Lazard could maintain performance and consistency in investment philosophy and portfolio construction, as well as continue to retain key decision-makers. In November 2003, having found that Lazard successfully fulfilled the majority of these evaluation points, Callan placed the manager back on active status.

Dan Price, senior manager of research with Schwab's managed account programs, noted that if "the turnover in a product is low, the risk of staying with the manager and watching is low. There is uncertainty, but not enough risk to warrant termination." When Lehman Brothers acquired Neuberger Berman in October 2003, for instance, Callan noted that "the deal has been structured appropriately to provide long-term incentives for key management professionals at Neuberger Berman. A back-loaded stock option program combined with non-compete contracts should ensure that integral members of the All Cap team remain in place."

Just as analysts use subjective analysis to determine the risks of people changes at asset managers, they also apply a measure of subjectivity to the usually numbers-based game of performance measurement. Unfortunately, neither objectivity nor subjectivity, nor a combination of both, seems able to head off poor performance before it happens. Said Smith Barney's Regan, "We know that management styles come in and out of favor, so we try to create an understanding of what to expect from a manager's investment process. When we are evaluating performance after the fact, there are questions about how particular biases do against a benchmark." Callan's Davison agreed: "It's very difficult to evaluate an underperforming manager. Take large-cap value managers for instance. They are not equal in their search for value. There is a low P/E approach, traditional value and relative value. Therefore, the question becomes, how are they underperforming relative to the other large-cap value managers?"

What's really difficult for brokers, however, is that individual investors rarely, if ever, think in these terms. According to Cameron Short, a senior vice president and financial consultant at Ryan Beck in Pittsburgh who has $140 million in managed accounts, "clients want to know how they did against the market." But he stresses that unless you show clients their performance against that of their peers, "you are hanging yourself out to dry."

Paul Hack, an adviser with Raymond James in Farmington Hills, Mich., who has more than 85% of his business in managed accounts, sees relative performance as an issue, too. He says that one of his greatest challenges over the past several years has been to explain to a client who has lost money that "they lost an appropriate amount, as opposed to an inappropriate amount." He believes that changing managers, while disruptive, is an integral part of running a managed account practice because it serves to reinforce the process. "When we replace managers, it lets the clients know we are doing our homework," he said. "If you never change, they always wonder if we are watching the managers."

Despite difficult choices that are part of the SMA process, historical performance suggests that the analysts conducting the due diligence on asset managers get it right most of the time. So what happens to managers and the clients whose funds they manage when the managers are dropped? Brinker's Harrington says that information about the termination of a manager from a platform flows along an unofficial but highly efficient communications network consisting of trade press reports, e-mails and chatter at industry conferences.

The largest issue that most clients face when a manager is terminated concerns taxes. If there are large unrealized gains with a particular manager and funds are allocated to a different manager with a different basket of stocks, investors face the likelihood of a steep capital gains tax bill. This is a serious issue for a product that bills itself as more tax-sensitive than mutual funds.

Price said that many advisors and brokers try to help their clients ease the process by transitioning them to managers where there is significant holdings overlap. Ultimately, Davison said, "there is no such thing as a perfect money manager." So despite the rigor of the analysis that goes into separate accounts, Schwab's Price believes that success for financial advisers and their clients rests 75% with the art of selection and 25% with science.

The next generation of managed accounts, probably the unified managed accounts that hold a broad array of asset types through a single platform, likely will solve some of the challenges that the current offering poses for advisers and investors today.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.