Separate accounts: Be careful what you wish for

Separately managed accounts are one of the few bright spots in the asset management business.

While mutual fund assets have contracted 3% annually since 1999, managed accounts have grown by almost 7% to $443 billion in 2 million accounts, according to the Money Management Institute. And by 2011, the Washington-based trade association projects, there will be 12.5 million accounts with $2.1 trillion in assets.

For many asset managers, grabbing a piece of this pie has been a panacea. The trucks pulled up and began unloading the money without any marketing to retail investors.

For others however, the value of separates programs has been questionable. The intensity of the relationship with sponsors and low margins have some managers wondering if they might have been better off not getting what they wished for.

Many asset managers are unprepared for the continuing demands of the due diligence, says Mark Pennington, who runs private-advisory services for Lord Abbett & Co. LLC, a Jersey City, N.J., asset manager. Lord Abbett runs separate accounts for eight sponsors.

“It is time consuming, and we need to prepare for it, and it takes time away from other things,” Mr. Pennington says.

Remember, the selling point for sponsors is the oversight of managers – hence, a level of scrutiny that would make an FBI agent proud.

“Because the sponsors can literally see right into accounts, it means they come in for their regular due-diligence meetings armed to the teeth with penetrating questions,” Mr. Pennington says.

A champion of the process because of the benefits it bestows on individual investors, he says that managers will find a steep learning curve in terms of articulating what they are doing to the standards of institutional scrutiny.

And keep in mind that managers really making a go of the separate-accounts business seek multiple platforms and face multiple inquisitions.

No one ever exited the separate-accounts business just because of the oversight. Some, however, have quit because the oversight, combined with narrowing margins, has made the entire proposition less tenable.

For instance, State Street Global Advisors Inc. in Boston made a well-thought-out foray into separate accounts and, after four years, made a well-thought-out exit. “What we learned is, the separate-account business is expensive to be in and requires a great deal of scale,” spokeswoman Alyson Riley says.

Marketing and operating costs are responsible for the thinning margins, says Mike Evans, an analyst with Financial Research Corp. in Boston.

At first blush, marketing costs for separate accounts might seem a misnomer. Isn’t the point of getting on such a platform to reduce the time and energy associated with gathering assets?

Perhaps, but because there truly is no such thing as a free lunch, a whole new marketing dynamic emerges. First, “money managers on an SMA platform need marketing people out in the field because they are the support mechanism for the brokers or RIAs or planners generating the assets,” Mr. Evans says.

More important, however, if a broker lands a big piece of business, and there is a large allocation to say, large-cap value, there is almost always an expensive and nerve-racking bake-off between the large-cap-value managers on the sponsor’s platform.

And the marketing muscle doesn’t come cheap. According to FRC’s most recent study on distribution trends, the combined base salary, commission and bonus for external marketers averaged about $248,000 in 2002, and on average, each manager had about four marketers on staff.

In addition, operations eat up 0.07 to 0.15 percentage points of the manager’s fee, which right now hovers at between 0.40% and 0.45% of assets – and somewhat less for fixed income. Achieving and maintaining connectivity with a sponsor’s platform is significant, particularly if a manager is on several platforms.

“Unlike the clearing and custody business, there is no central platform, and the operating personnel spend a lot of time simply logging out of one system and into another,” Mr. Evans says. (As Jeff Benjamin reported in InvestmentNews last week, the industry has filed plans with the Securities and Exchange Commission for a standard operating system.)

The bottom line is an approximate 20% margin on the management fee of 0.40% to 0.45%. While a double-digit operating margin is pretty good, it needs to be considered against the staying power required to get there.