If you've got half a million dollars lying around, financial advisers have a hot investment product to sell you: a separate account. But it might not be worth the money you pay for it. Long the province of the ultrarich, separate accounts sound exclusive. But as investment minimums have dropped in recent years, so has the level of personalized attention.

A separate account is a customized portfolio of stocks and bonds, often set up by one of the major brokerage houses but run by outside money managers. The accounts typically require an investment of $500,000 or even less, down from minimums of $1 million or more as recently as four years ago.

Because they're made up of individual securities, separate accounts claim to offer tax-planning advantages that mutual funds can't provide. That explains much of their appeal to well-heeled investors.

"Separate accounts are 'in' and mutual funds are somewhat struggling, at least from a perception standpoint," notes a recent report from Cerulli Associates, a research and consulting firm. Explains Cerulli's Paul Fullerton: "As the high-net-worth demographic grows, more and more people want the tax advantages and customization you can get with separate accounts ."

Even leading up to the market downturn, growth in separate accounts was outpacing that of mutual funds. In the five years ending in 2000, separate account consultant programs grew at a compound annual rate of 26.1%, well ahead of mutual funds' 18.4%. Granted, accounts are growing from a smaller base, but the interest is still significant.

It has helped that some of the nation's biggest brokerage houses, such as Citigroup's Salomon Smith Barney and Merrill Lynch, are pushing the concept, lured by the prospect of fat fees. "The mantra from the higher-ups is to do fee-based business," explains Fullerton. "And the separate-account-consultant wraps also align with the clientele they're going after: high-net-worth investors."

The Knock on Separate Accounts

Despite the growing popularity of the products, many financial planners question their value. "Frankly, I think they're more of a fad and something cool to talk about at cocktail parties," says Rick Adkins, a certified financial planner for Arkansas Financial Group in Little Rock. "It sounds good in theory, but they're not nearly as personalized as most people are led to believe."

Indeed, the accounts may have become too democratic. "Separate accounts are victims of their own success. Instead of $1 million investment minimum accounts, now there are accounts with investment minimums of only $200,000. So there are a lot more accounts to deal with," says Scott Leonard, a certified financial planner with Leonard Wealth Management in Manhattan Beach, Calif.

Because of his bad experiences with separate accounts, Leonard no longer recommends the products for clients, and sticks mostly to low-cost, tax-advantaged mutual funds instead. "People think when they open separate accounts, the manager is looking at their account on a daily basis and overseeing their personal pot of money. But that's not what happens at all," Leonard says. "Managers have a buy list of stocks, and they go into everybody's account at once and sell IBM and buy Dell."

In fact, because separate accounts typically rely on outside money managers, investors don't actually know who's in charge of their portfolios. "You get a generic portfolio of whatever investment objective you fall into," says Michael Boone, a certified financial planner in Bellevue, Wash. In other words, managers may lump clients into "growth" or "growth and income" categories, and therefore treat these investors in the same way.

By managing money in-house, Boone's firm essentially competes with separate accounts. But he contends the arrangement works out better for clients because he can tailor investments to their financial and tax situations.

A more troubling problem with separate accounts is that they often don't deliver on their promises of tax advantages, which is the reason many investors chose them. In theory, at least, the accounts allow for more careful tax planning than funds because they consist of individual stocks or bonds. Managers are supposed to be able to sell securities at a loss to offset current or future gains. Also, investors aren't buying into pre-existing capital gains.

But in practice, managers often don't pay attention to the tax consequences of trading. "We've seen instances where a trade in a separate account took place three days before the short-term capital gain turned into a long-term gain," says Adkins. "A lot of times managers don't track the short-term and long-term differential on capital gains."

"There are numerous examples where people utilized this kind of product and the alleged benefits over mutual funds were nonexistent," he says.

Extra Expense

In addition, it's typically more expensive to hire an outside manager than to have your financial adviser buy stocks (or funds, for that matter). "If you're hiring an outside manager, there are two levels of fees. Common sense tells you that would be more expensive than if you did it in-house," says Boone. "But if the financial adviser is managing money personally, it's almost always going to be cheaper than hiring an outside firm."

Boone says total fees for a combination of money management and a mutual fund wrap at his firm would typically range from 1.4% to 2% of assets. By comparison, fees for outside-managed separate accounts typically range from 1.5% to 3% of assets, covering management, trading and custodial costs. A separate account could cost up to 100 basis points extra, he says. "On a $1 million portfolio, that's $10,000 a year."

Or consider another arrangement: Leonard's firm doesn't run any of its own money, relying mostly on mutual funds. It charges either an annual retainer in dollars or an asset-based fee of up to 1%. On top of that, domestic mutual funds cost between 18 and 35 basis points. "That compares to 50 basis points and up for a separate account," he says.

Of course, the extra money might be worth it if your investment through a separate account produces higher returns. But in practice, planners who've used separate accounts for their clients say they don't perform any better than mutual funds.

Funds also win out when it comes to disclosure. They're much more closely regulated than separate accounts, and there's far more public information available about funds, which makes it easier to measure their performance.

Meanwhile, separate-account managers may say they adhere to industry standards for calculating their composite investment returns (set out by the Association for Investment Management and Research), but there's currently no independent body to verify those claims. "We've learned a very good lesson via Enron that self-auditing doesn't necessarily mean you're getting the truth," says Leonard.

Indeed, even planners who use separate accounts agree investors should be wary, especially when it comes to broker sales of the products. In some cases, "it tends to be more of a package sale than an investment solution," says Harold Evensky, a certified financial planner in Coral Gables, Fla. "An investor needs to do due diligence on who the person at the firm is whose advice they're paying for."

In Defense of Separate Accounts

But in defense of the accounts, Evensky says "the more thoughtful managers" can offer sophisticated tax management. "Even with someone in the 30% tax bracket, that still makes a very big difference." Also, accounts are more customized than mutual funds: Managers can take into account any pre-existing holdings a new investor may own and not buy those stocks.

Evensky doesn't dispute that those services, plus his own advice, will cost clients extra. "It's not a question of whether they pay more, but it's whether they're getting something for it," he says. "I select the manager, monitor how he's doing, hire and fire him. I think they get far more than their money's worth."

Still, the bottom line is buyer beware. If you're thinking about opening a separate account, ask a lot of questions about the level of service you can expect. Because, sadly, the guy with a $200,000 account doesn't get the same love as the heir of a robber baron. "If someone walks in to a separate-account manager and they've got $10 million and above," says Leonard, "they would definitely be able to demand the attention appropriate for them." The rest of us mortals should think seriously about mutual funds.