It's the newest "it product." With assets projected to grow annually at 23%, separately managed accounts (SMAs) could quite possibly become the hottest investment product of the decade.

But little has been said about how to penetrate this market, or how mutual fund companies, most of which are third-tier in this space, are going to compete with top-tier asset management firms with an established foothold in separately managed accounts.

"The high cost of entry is prohibitive, except if you distribute someone else's branded product," said Matt Schott, an analyst with Tower Group of Needham, Mass. In addition, SMA profit margins are said to be about half of those of mutual funds.

So, why are so many fund companies scrambling to offer these products when there are so many drawbacks and only an estimated two million accounts with $400 billion in assets?

Fund companies "need this as one of their service offerings," said James S. Greene, VP of financial services of the Americas for Cap Gemini Ernst & Young. Or as Kevin M. Keefe, VP and senior consultant with Financial Research Corp., put it at The Money Management Institute conference in New York earlier this month: "Because that is where the money is."

About 75% of SMA funds are held by five wirehouse powerhouses: Merrill Lynch, Morgan Stanley, UBS PaineWebber, Prudential and Citigroup's Salomon Smith Barney.

Though the road to creating a successful SMA program is littered with hurdles, analysts and bankers interviewed say there are a few key points to remember.

1. Focus on profit by controlling costs.

The key word in SMAs is "profitability." Once an SMA program operates past the breakeven point, gross profit margins hover between 17% and 23% in years six through 10.

Keeping equity turnover low is one way to hold expenses down. The average turnover in separate accounts is 75% and the average security is held for only 16 months.

Moreover, margins are low. Management fees for SMAs have dropped from 3% in the early 1990s to 1.5%, according to Celent Communications, which recommends an SMA return on assets (ROA) of 1.5% to 2.5% and a return on equity (ROE) of 15% to 19%.

Remaining cost-efficient is, therefore, a major priority for any new or existing separately managed account.

2. Set profitable account minimums.

Cerulli estimates the SMA business for all financial institutions is less profitable than the retail mutual fund business. But the larger the account, the higher the profit.

According to Lockwood Financial Services research, the average managed account is $250,0000. While the industrywide account minimum used to be $1 million, many banks, accept accounts of $100,000. But TowerGroup warns that tax savings are attractive only for accounts of at least $250,000. Going further, TowerGroup says at least $750,000 is required to be properly diversified.

3. Determine what to outsource.

Many experts are advising fund companies to choose between manufacturing and distribution.

"If you have no economy of scale and you're starting from scratch, building it isn't the right way to go," said James Paolini, director of investment consulting at Wells Fargo Private Client Services.

More than 40 vendors now offer SMA services, from investment management, to back-office support, to distribution and marketing. Operational functions - account opening and closing, account maintenance, account reconciliation, marketing fulfillment and performance reporting - which make up about one-third of costs, is a logical first outsourcing choice, according to Cerulli Associates.

"Every outsourcing firm has polished and tweaked and tinkered their solutions and has a comprehensive approach to SMAs," said Christopher L. Davis, executive director of The Money Management Institute.

Major vendors in the outsourcing space include FundQuest, BISYS Investment Services, Checkfree, EnvestnetPMC, SEI Investments and Brinker Capital.

Even Wells Fargo, another big-bank name in managed accounts, has outsourced with London Pacific Advisors for an SMA platform.

In fact, banks should outsource SMA accounts 100% of the time - at least at first, said Jim Seuffert, who heads Lockwood Financial Services, the largest provider of individually managed account services to independent financial advisers. With $6.8 billion in SMA assets, the eight-year-old firm in Malvern, Pa., was purchased by Bank of New York in October.

One area where investment firms should retain control is due diligence, due to fiduciary responsibility, Paolini said.

4. Give clients access to a truly wide scope of choices.

There's no excuse for not offering clients a wide breadth of best-of-breed products, according to analysts. And while you're at it, figure out how to encompass multiple investment styles - hedge funds, mutual funds, exchange-traded funds and variable annuities into accounts - and then make it accessible on one platform, because that's what clients expect.

"There is meaningful research that says HNW clients are taking advisers less and less seriously if they're not offering them overarching platforms," Keefe said, pointing to a recent Spectrum Group study indicating 61% of high-net-worth clients believe an adviser can't be objective unless his SMA provider offers outside products.

5. Determine if your technology is an asset or liability.

Technology is the first word out of the mouths of SMA managers, who believe being on the cutting edge is the only place to be. Unlike the mutual fund industry, the SMA industry is automation-challenged, with few standardized processes and data still being processed via faxes, e-mails and phone. But that is changing rapidly, as vendors rush to respond to increasing demand for integrated platforms. Setting up a managed account once took nearly two days, but today it only takes 20 minutes, according to analysts.

The industry can expect to be transformed in the next few years: Celent estimates spending on managed-account technology will double to $576 million in 2003 from $278 million in 2000.

6. Pay special attention to overlay portfolio management in multiple-discipline accounts (MDAs).

Most MDAs employ either an outside or inside overlay portfolio manger (OPM) to coordinate managers of all account disciplines. "The OPM allows the smaller investor to achieve diversification that can't be achieved with smaller account sizes," said MMI's Davis. "The OPM is the hottest topic in SMAs."

An effective OPM can dramatically improve portfolio performance and cut expenses. The OPM can add 0.3% to 0.6% or more annually in net after-tax return, according to a report by Parametric Portfolio Associates and SEI Investments - which is critical since the typical HNW investor loses 25% of his total return to costs and taxes.

7. Emphasize superb service.

Hands-on client management, preferably team-based, is at the top of the list of expectations of SMA clients, who are becoming increasingly more demanding, requiring monthly reviews of target allocations, quarterly rebalancings and twice-annual tax reviews.

Moreover, because the client sees the adviser fee, whereas a mutual fund fee is hidden in the small print, he or she is more acutely aware of the price of advice.

According to Davis, the five hallmark features of quality service are development of a policy statement, determination of risk tolerance, selection of money managers, monitoring of performance and rebalancing of portfolios.

Ironically, analysts say, SMA clients are less concerned with profits than process. They want proven strategies for building wealth and they want to be consulted often.

8. Integrate private banking, trust and brokerage units.

Fund companies owned by large investment or commercial banks should leverage their private banking, trust and brokerage units, said Stuart Parker, managing director and head of distribution for private accounts at Salomon Brothers Asset Management, a unit of Citigroup.

One final note. Fund companies edging into the separately managed account business are not only competing with the Lockwoods, the Brinker Capitals and the CDC IXIS'es of the world. "The banks are going to get into this business, and they'll come stampeding," Davis said.

Copyright 2003 Thomson Media Inc. All Rights Reserved.,

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