The separately managed account industry is just reaching the tip of the iceberg.
That is the battle cry heard from Len Reinhart, president of The Bank of New York's separate account services unit and a founding father of the wrap fee industry. He believes that the SMA business is where the mutual fund industry was in the mid-1980's and that with the help of technology and advertising dollars, the product will achieve extraordinary growth and become an increasingly popular investment vehicle for investors looking for customization and tax benefits in their portfolio.
Reinhart, a 25-year veteran of the financial services industry, is credited with developing programs that introduced institutional-level professional investment management services to the individual investor. He serves on the board of governors of the Money Management Institute and on the advisory board of directors of the Institute of Investment Management Consultants.
Reinhart founded the Lockwood family of companies in 1995 and helped launch its Electronic Managed Account Technologies, its Web-based platform for money managers and program sponsors. Lockwood merged with Bank of New York in 2002 to compete with the major wirehouses in the separate account space. For more on his conversation with Money Management Executive Associate Editor Kevin Burke, read on.
MME: When you first ventured into this business, what were your expectations?
Reinhart: I was like 23 years old, so I'm not sure I envisioned too much - other than a job. (Laughter.) But I entered on the analytical side of the institutional pension market at E. F. Hutton. Pension funds had to put prudent investment strategies and policies in place because there were a lot of abuses in the industry. We started working on the big institutional side and trained our brokers to work with smaller pension funds. From there it transitioned from the pension business to the high-net-worth business.
I saw it evolve from an institutional marketplace to slower growth to no growth as the 401(k) market came into being. From there, the responsibility of taking care of one's retirement shifted more and more to the individual. Eventually, it brought us to where we are today with no new corporation creating a pension plan. Traditional defined benefit pension plans are dinosaurs.
So, I've seen a complete transition of the business from an institutional mindset to an individual mindset. I'm not sure I envisioned any of that happening but rather adapted to it.
MME: Did the growth of the business exceed your expectations?
Reinhart: You know, it's funny. I look back on it, and it seemed like it was painful and sluggish. I remember back at E. F. Hutton when we had about $12 million in assets on the retail side. So the numerical growth has been astronomical and the amount of wealth created changed hands over the past 25 years.
Getting back to the separate account industry and what we're doing on the high-net-worth side, I've always felt it should have gotten there quicker, meaning, that SMAs had all the attributes of mutual funds but were better because they could be customized. Yet, technology really didn't allow for that until the last seven or eight years.
So it really didn't get its due as we went along until recent years. I still think now we've just reached the tip of the iceberg with SMAs. I think we're at where Vanguard and Fidelity were in the early 80s in terms of their popularity. Those weren't household names, and all of a sudden the press got behind them and clients started to understand them. A major education process got underway and they took off dramatically.
I think we're at the beginning of that cycle in the SMA industry. I think you're going to see tremendous growth over the next decade as the education and advertising campaigns kick into gear and people realize their true features.
MME: You founded Lockwood in 1995, but after seven years you merged with Bank of New York? What led to that partnership?
Reinhart: It was really an effort on our part. We had taken Lockwood as far as we could take it as an independent, legally. And by that I mean we've grown from nothing to over $9 billion in assets. So we've sort of blown through the boutique players out there, and all of a sudden we were competing with the Schwabs and Fidelitys of the world, and we didn't have the resources to do that alone. We couldn't organically grow it anymore and compete with those people.
In the beginning, they probably took a look at us and said we don't have to worry about them, but then we started to get business. Suddenly, somebody gave me one of their business plans and it identified us as one of their major competitors.
We realized we were entering a different world here and we didn't have the resources. So we went out and hired a banker and identified who would be a great partner for us. We didn't do our acquisition the traditional way where you put a binder together and you send it to a thousand firms. We targeted a handful of firms and met with them to try to find the right fit, and what Bank of New York brought to us was resources. Even though they're a bank, they're really one of the largest back-office providers to the financial services industry in the world.
They have connections with nearly every financial institution, which was a leverage point for us in that we could start to distribute our products through their relationships that were already built. And that got even magnified to a greater degree when we found out they were purchasing Pershing, which furthered leveraged Lockwood's ability. So it's working out very, very well for us.
MME: What, specifically, are some of the positive things that have come out of this merger?
Reinhart: The most immediate impact was we went from having to purchase clearing to being a self-clearing firm. We were competing with the wirehouses, Schwab and MFS, which were all self-clearing. Now, we can custody and clear the money as well as provide services, which gives us a definitive pricing advantage. We were able to broaden our product array dramatically. We went from basically offering separate accounts to our advisers to offering separate accounts, mutual funds, hedge funds, mortgages, muni bond ladders, passive fixed income. We've expanded dramatically the depths of services and will continue to do so. We're going to be offering collateralized loans in the not-too-distant future.
Prior to doing this, we were sort of an exception provider, meaning we provided a niche product. Now we're able to go to an adviser and compete at the level of a Schwab or an MFS and offer a full array of products. Competitively speaking, we went from a one-trick pony to the whole circus. And that's probably the quickest thing we've done since we've become part of Bank of New York and Pershing.
MME: What is unique about your firm's investment strategy that sets you apart from the pack?
Reinhart: I think it hinges on customization. When we built Lockwood, we targeted the high-net-worth individual. As I said, my background was in institutional and the smaller pension market, and so where I came from, their book of business was still heavily weighted toward that type of market.
At Lockwood, we said, "We're not going to target that business. We're going to go specifically after the high-net-worth individual." So there was a year when we had no clients. We had 45 people on staff, a lot of it research, a lot of it technical and we were targeting the high-net-worth individual. So we built a platform specifically for them, focusing on customization and after-tax results. It's about hitting hard-dollar goals with as high a probability as possible.
When we had no clients, we had the time to really think through and start fresh with what we were doing, and that's why we had to build a lot of the technology to really take advantage of the customization that we do for clients.
I get upset when people say SMAs really aren't that customized. Well, those individuals haven't been here, and they haven't seen the number of calls we get in November and December on tax-loss harvesting and the number of exceptions we have on accounts. You know, "Don't buy this industry or this stock." We really do that customization and put the technology in place to do it, and I think that's what makes us a lot different than a lot of the people offering SMAs.
MME: Switching gears, what impact has the bear market had on your business?
Reinhart: Well, the obvious impact, you know, is that in the bull market, everything was focused on sales because your asset base was going up. All the money managers were focused on capturing new accounts. And as far as operational expense, everything just kept going up, which was fine as long as revenues continued to rise accordingly.
As we got into the bear market, for the first time in the separate account industry money managers didn't make as much money as they made before, and this forced them to look at their infrastructure and operational costs. It was an eye opener - particularly as people began to realize that the operational expense of processing this business is very high and that the industry has not done a very good job in streamlining and hooking its operations together.
It's like the U.S. trying to build a railroad system with each state building its railroads with a different gauge track. Right now it's very inefficient. Each sponsor has their own gauge track, and I think the industry has woken up to the fact that we've got to get together and put operations standards in place. It's nice to see there's some movement in that direction now.
MME: Is it possible we could move toward a trading processing standard that all advisers could use?
Reinhart: Yes, but I think it's more than just trading. It's sponsor consistency, meaning the inputs and the outputs should be the same for each sponsor program. Trading is just one piece of the various operational procedures. This is what I was talking about, where each sponsor is like a state with their own gauge railroad. The money manager is forced to try to travel on all the different railroads, so it's more than just trading.
Here, too, we're probably at the point where mutual funds were in the late 70s where each mutual fund company did its own operations. Finally, some major players like Bank of New York, State Street and DST got in and took over the processing of mutual funds, including the creation of NSCC for mutual fund trading. The result was that the cost of processing funds dropped dramatically and is measured in fractions of basis points.
MME: Does that tie in with what AIMR is trying to do with its performance presentation standards?
Reinhart: It's a little bit different, but what's the same is it's trying to come up with standards. I applaud AIMR for listening to the Money Management Institute plead its case. I gather they're going to come back with something that's more reasonable.
MME: Where does that stand right now?
Reinhart: The major issue is this: By the nature of SMA accounts being customized, based on the parameters you put on the account and your specific tax circumstances, no two investors get the same result. So it's difficult to measure
The premise is everyone wants to see a number that represents how that manager has done. Well, in the mutual fund industry that's pretty easy. In the institutional business, where you don't have taxes, that's relatively easy. In the separate account area, trying to identify a number that represents how all clients did with a money manager really isn't that practical.
If you want to really make use of these accounts, you're going to have to customize, and you're going to have variables. That makes the performance AIMR would like to track very hard. So I think it almost ends up having to be some sort of range. It's a difficult issue. By the nature of the beast, unfortunately, it doesn't fit into a nice, clear-cut bucket.
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