Scandal-Proofing With Separate Accounts

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."