Operational inefficiencies are nothing new for the separately managed account business. In fact, the lack of connectivity between its key players has stunted what has otherwise been rapid growth in recent years.
Indeed, assets held in separately managed accounts industry-wide ballooned to $506.63 billion at the end of 2003, eclipsing the half-trillion dollar mark for the first time, according to industry trade group the Money Management Institute. But like any business, with growth comes new challenges, specifically when it comes to technology and building infrastructure.
Trade order management, for example, has become a major cause for concern for both managers and sponsors because of the growing need for best execution for the client. In order to trade securities for their customers, sponsors must receive orders from the portfolio manager and deliver that information to a trading desk where the transaction will take place. The systems and software used to transfer the data are often incompatible or require extensive training. Due to that lack of direct linkage, it can result in much of the transaction being handled manually.
Stepping Out
This problem is perhaps best illustrated when placing small orders or trading small-cap stocks. If a firm wants to blow out an entire position in a small-cap stock, it could really move the market completely away from them. As executions happen, the firm would get worse and worse execution on their orders. So in order to achieve best execution for the client on smaller, illiquid stocks, sponsors tend to go outside the normal rotation to get the best price or "step out" the trade. Essentially, stepping out has to do with liquidity or size of the trade.
Since many firms lack straight-through processing, these types of trades can be pricey and cumbersome. "Most of the sponsoring firms that are executing the trades don't really have electronic systems to handle the transference of the executed orders from step-outs, said Vincent LePore, senior advisor at the MMI "It's more of a manual process." On top of that, there may be some additional costs that go along with stepping out the orders that a client would have to absorb, he noted.
"The reporting process is outside of the norm and they have to have a way to come back and reconcile it to their accounts," said Jim Vitalie, president of Curian Capital of Denver. "That requires more work for the sponsor and the money manager."
The more hands trades have to go through to get completed not only slows down the process, but also makes them more susceptible to error. Anyone who has played the telephone game as a child knows that the original message gets distorted as it gets passed along to more and more people. With managed accounts, there is a similar problem of a communication breakdown between money mangers, sponsors, clearing firms and other participants.
Consider another example of trading inefficiency. Manager XYZ wants to sell all IBM positions for managed accounts, so it sends the order out at 9:45 a.m. to the big five Wall Street firms, all within three or four minutes of each other. Hypothetically, let's say one of the reps from Smith Barney is not available or the order is sent by fax and he doesn't receive it until 10:30 a.m. Meanwhile, three other firms got their order and executed it right away. Yet another rep was in meetings until early afternoon and didn't receive the trade order until 2:30 p.m.
This creates a disparity among the IBM orders, which further suggests that there is an inefficient link between managers and sponsors. Currently, managers are not receiving order confirmations on these trades within minutes of sending it to the sponsor, which creates a real problem for the manager and can prevent the client from getting the best price. The order placed at 2:30 may have missed the opportunity to sell at the desired price relative to other orders placed almost simultaneously. Or perhaps the first in line will have gotten the shaft.
Rotation Intimations
Money managers use trading rotations to help them manage best execution issues, but they must have specific policies in place to make sure that rotation is followed. If it is not followed, they risk best execution for the client and may tip their hand when the orders hit the floor of the exchange.
"It is difficult for the managers because the industry doesn't have the greatest technology or connectivity," said Michael Evans, vice president, director of separate account research at Financial Research Corp. of Boston. "Some firms have 25 to 35 relationships, trading through all sorts of platforms using many different systems. They have to be careful that their clients get best execution," he said.
Given the current regulatory landscape, it is hard to imagine that SMA providers won't eventually come under the microscope for any conflicts of interest or inappropriate trading practices. "It almost seems inevitable that the SEC will more or less bring them under the same regulatory framework as the fund industry," said Charlie O'Neill, principal at MutualFundCareers.com. "It will probably take a scandal in that business to get them to do it." Based on that assertion, it is now more important than ever to have a written trade rotation policy in place in case regulators come knocking on the door.
In light of the recent emergence of next-generation products such as mutli-discipline accounts, there has been even more emphasis on trade execution. "When you implement new programs such as overlay management, you need to address trade-order rotation and all the rules around step-outs," said Matt Schott, a managed accounts analyst at Tower Group.
Wheel-Borrow?
Last year, the MMI commissioned Deloitte & Touche to study operational interfaces in the SMA industry. Deloitte concluded that trading inefficiencies could be expected to "result in errors with an adverse economic impact", according to an SEC release. The authors of the study have urged the MMI to look beyond its current technology and operations platforms to seek an industry-wide approach that would allow the SMA industry to achieve standardized and centralized processing, similar to what the mutual fund industry has accomplished over the last 20 years.
A potential solution to trading inefficiencies is currently being kicked around by members of the MMI but will not be formally addressed anytime soon. The information messaging system built by National Securities Clearing Corp. will help the process slightly by offering a centralized platform for the communication of basic account opening and maintenance data among sponsors and investment managers. But it still won't have a meaningful impact on trading, LePore said. Trading issues will be addressed in a later-stage NSCC product, but for now it is merely conceptual.
Nevertheless, getting to that stage of the game could take a fast track. That's because there are other standards in place throughout the financial services industry that work very well for trading. "Instead of reinventing the wheel, we could just adopt and make sure the wheel fits," LePore said.
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