Gregg Greenberg

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Scandal-Proofing With Separate Accounts

Gregg Greenberg

Do you know what makes a peaceful vacation with the kids? Separate rooms.

Do you know why Rob and Laura Petrie had such a happy marriage on the Dick Van Dyke Show? Separate beds.

Most importantly, do you know the best way to avoid the mutual fund mess entirely? Separate accounts.

A separate account, also called a managed account, is a professionally managed portfolio of individual securities. Like a mutual fund, a separate account offers investors diversification and experienced management. Unlike a mutual fund, investors don't have to worry about mixing their stocks with those of market-timers, late traders or any other unscrupulous market miscreants. All the stocks in a separate account are held in your own name and in your own account.

In light of the scandal in the mutual fund industry, what are the pros and cons of separate accounts?

The first major difference between mutual funds and separate accounts is the account minimum. With a typical minimum of $100,000, separate accounts are usually distributed by the private client services divisions of major investment houses and marketed to high-net-worth investors. Most mutual funds, on the other hand, have minimums in the $1,000 range.

The steep minimum for separate accounts is more a function of economics than elitism. Money managers have serious difficulties properly diversifying amounts less than $100,000 into the proper amount of names without leaving small odd lots of stock here and there. Therefore, the bar is set high before the process becomes too unwieldy.

Nevertheless, for those investors who are mad at their mutual fund companies but not yet in the moneyed class, don't give up on separate accounts just yet. For instance, GE Private Asset Management seems to have solved the diversification problem well enough to be offering separate accounts with minimums of $50,000.

Furthermore, as with high-end electronic items such as TVs and VCRs, products that are originally targeted toward the upper classes eventually trickle down to the burgeoning masses.

"The trend towards managed accounts preceded the mutual fund scandal," says Christopher Davis, executive director of the Money Management Institute, an organization representing the separate account industry. "All things begin with the high-net-worth client and work their way down."

Once you get past the minimum, what are the unique advantages of separate accounts?

Investment advisers say customization is a huge plus. The portfolio of stocks and bonds in a separate account can be tailored to the client's needs. If an individual wants to avoid sin stocks such as cigarette manufacturers Altria(MO Quote) or R.J. Reynolds(RJR Quote), they can be left out of the portfolio. If the individual thinks sinning means winning, then he or she can put them back in.

"Separate accounts are more personal than mutual funds because they take into account your personal situation," says a money manager based in Connecticut. "For example, if you have a client who is an executive at McDonald's, you can lighten up on fast food and restaurant stocks."

Personalization also means tax-efficient trading, a problem that mutual fund managers have difficulty solving.

In a separate account, money managers can time a client's trades for optimal tax treatment based on the client's specific needs. They can take into account a client's cost basis and try and net out the huge capital gains that create huge tax bills in April.

Mutual funds, on the other hand, are far less tax sensitive to the individual holder. In April 2001, for example, many mutual fund investors not only saw their net asset values move lower after a tough prior year in the market, they were hit with large tax bills to boot. Unfortunately, the insult to their injury came from capital gains created by trades made by their funds early in 2000.

High-Net-Worth Service at Mutual Fund Prices

Surprisingly, for such customized service, the fees for separate accounts tend to be quite reasonable, and in many cases cheaper than mutual funds (see chart below). Most separate account programs charge a simple fee based on assets under management, rather than a commission-based fee structure. In addition, the fee percentage usually declines on a sliding scale as assets under management increase.

According to the Money Management Institute's Davis, the popularity of separate accounts goes hand in hand with the recent move toward fee-based investment advice. With $7 trillion in assets under management, the mutual fund industry currently dwarfs the managed account world, which, according to Cerulli Associates, at last check held only $450 billion in assets. Nevertheless, Davis says the "demand pull" from investors for such vehicles, plus the "supply push" from investment firms trying to change the fee structures of their businesses, is creating a boom in the separate account industry.

Mutual, Not Mutually Exclusive, Fund

Although investing in separate accounts and mutual funds might seem mutually exclusive, that's actually not the case.

"Mutual funds and separate accounts can complement each other and work together as part of an overall investment solution for the client," says Mark Pennington, a partner and director at Lord Abbett & Co. "It does not have to be one or the other." Lord Abbett & Co. maintains 60,000 separately managed accounts with more than $16 billion in assets, making it the second-largest independent manager behind Brandes Investment Partners, which has $25 billion.

"If I was buying something like high yield, where you want more diversification of that asset class, then a mutual fund might be better than a separately managed account," says Pennington.

Other investment advisers echo Pennington's sentiment that separate accounts are a great tool when used in conjunction with other private banking services. Said one investment adviser, "Separate account clients not only get professional money managers looking after their individual accounts, but they get the whole private banking package as well."

Comparison of Managed Accounts and Mutual Funds
	Mutual Funds	Separate Accounts
General Features
Access to professional money managers	Yes	Yes
Diversified Portfolio	Yes	Yes
Ability to customize portfolio	No	Yes
Unlimited withdrawals/redemptions	No, most funds have restrictions	Yes
Typical account minimum	$1,000	$100,000
Liquidity	Typically, next day	Three-day settlement of trades
Access to asset classes	Numerous	Somewhat more limited than funds
Performance Reporting Features
Performance reporting	Typically semi-annual, some more frequent	Quarterly performance rating
Customized performance reporting	No	Yes
Tax-Related Features
Unrealized gains	Yes, average U.S. mutual fund has a 20% imbedded, unrealized capital gain 1	No, cost basis of each security in the portfolio is established at time of purchase
Customized to control taxes	No	Yes
Tax-efficient handling of low cost basis stocks	No	Yes
Gain/loss distribution	Virtually all gains must be distributed, losses cannot be distributed	Realized gains and losses are reported in the year recorded
Cost-Related Features
Expenses (excluding brokerage costs)	1.42% 1,3	1.00%
Expenses (including brokerage costs)	1.56% average 2,3	1.25% 3
Volume fee discounts	No, all investors pay the same expense ratio	Yes, larger investors enjoy fee discounts
Other costs	12b-1, sales loads, redemption fees, etc.	None
1. Morningstar Principia Plus for Windows, February 2002 2. Brokerage costs estimated at 0.13% for the 10 largest funds 3. Costs do not include Adviser fee, which will vary Source: The Money Management Institute

Most major brokerage firms either offer their own proprietary manager programs and/or third-party manager programs, in which the broker-dealer has an arrangement with an outside money management firm.

In order to decide which third-party managers to offer clients, brokerage houses review manager performances and perform due diligence. Nevertheless, even after the firm picks the managers it wants to carry, individual brokers often cull the choices down even further.

One high-net-worth broker said, "The firm has over 200 managers, but we stick with only around 20." He also said the wide array of choices can lead clients and firms "to chase managers with a hot hand." This is a practice he views negatively.

Another problem for both the broker and the client is the vast amount of paperwork it takes to open a separate account. Since the manager is effectively getting discretion over the client's account, both sides need to be aware of suitability in order to avoid liability.

"Sometimes it takes a couple of days to get all the signatures necessary and the documents approved by compliance," said an Atlanta-based high-net-worth adviser. "By the time you finally put the money to work, the market might have moved significantly. Mutual funds are much quicker."