Myths and preconceived notions can rob your clients of extraordinary benefits.

Not so long ago everyone knew the earth was flat and at the center of the universe. Lightning never struck the same place twice. Touching a toad caused warts and you always had to wait an hour after eating before swimming. At one time all of these beliefs were held as true, until reason or an advance in scientific knowledge exposed the fallacy of these convictions.

Some of us unwittingly nurture our own sets of myths. While money may not grow on trees, given the amount of misinformation circulating in and around separately managed accounts, we might be given to seriously reconsider the dubious connection between forestry and cash.

Whenever an advisor provides incomplete information about oft-misunderstood SMAs, clients are then left to their own devices to conjure up visions of what these vehicles are. These would include tax-free, high-performing, low-minimum, custom portfolios, each personally run by the presidents of institutional money management firms. In other words, myths-by any stretch of the imagination.

Clearly, the benefits of managed accounts are aggressively marketed by their creators and promoters. Books, brochures, training seminars, Web sites, value-added educational programs and tools are all readily available. Even so, client-centric advisors with the best intentions may not be providing their clients with the most accurate information about SMAs. Consequently, more clients are quizzing their advisors about the differences between these individual accounts, and other products such as mutual funds. 

There are numerous misconceptions about separate accounts, and one of these myths surrounds the idea of tax efficiency.  So much can be done, for instance, with the newer structures of managed account products such as MDA-type accounts (multiple strategies), which focus on providing tax-efficient techniques. Overlay portfolio managers (OPMs) have the ability to manage tax liability across a variety of manager styles, with the bonus of also guarding against overlap of security positions and facilitating better diversification. SMA tax efficiency may be mislabeled as a myth simply because some advisors and their clients fail to take advantage of specific management features these accounts offer. Or because either they don't understand it themselves, or are not explaining it properly. This is where some basic talking points are helpful. Let's explore a few popular misconceptions clients may have, and help clear them up.

Myth Or Reality: Managed Accounts Are (Always) Tax Efficient

Reality. According to Gregory Gloeckner, president of Eastern Point Advisors, the advisory subsidiary of Investors Capital Holdings in Lynnfield, Mass., "The answer in general is 'yes.' However, if the manager is not managing the portfolio with tax efficiency as a goal, the portfolio will not necessarily have a better after-tax result."

The important point is that with separately managed accounts, the advisor and the client have the possibility to better manage the client's tax liability. Says Alan Sislen, SMA pioneer, president of Managed Account Perspectives LLC and former director of Merrill Lynch's Investment Consulting Group, "If a client has a specific tax situation one year and needs to take gains, but has a different tax situation the next year and would prefer to take losses, he or she has the ability to go through their managers to take advantage of that strategy."

Sislen explains that every client situation is different and the fact that an advisor and a client don't take advantage of this benefit (or don't need it that year) doesn't negate it. "The myth is propagated," he says, " because so few clients actually take advantage of it.  But the point is that the client has the benefit available. The benefit may not be of any use for the client four out of ten years, but in those years that it provides an advantage, the benefit can be enormous." 
     "This tax thing is pretty cut and dry," says Jim Owen, a partner in Austin Capital Management in Austin, Texas, and co-founder and chairman emeritus of IMCA. "Mutual funds are notoriously tax-inefficient, as we know. Typically there is very high account turnover, lots of trading activity. If you're [talking to] a portfolio manager for a mutual fund he or she will tell you, 'My job is not to be tax efficient; my job is to produce returns. Unlike hedge funds I can't use leverage and I can't sell short.' The imbedded taxes are real serious issues for investors." 

Myth Or Reality: Managed Accounts Offer A High Level Of Customization

Reality. Again, the myth that customization is just hype is kept alive by clients and their advisors who don't take full advantage of this feature of managed accounts. Customization relative to these accounts involves restricting certain types of investments-so-called 'sin' stocks, like tobacco or alcohol-or limiting investments to stocks of socially or environmentally conscious companies. "The client, through the advisor, can restrict certain securities so that the manager does not buy them for that particular client," explains Sislen. 

The customization of the portfolio and the ability for the client to restrict certain types of securities is often underutilized. "I haven't seen any hard numbers on this, but anecdotally, my experience says that somewhere between 10% and 20% of SMA clients use this capability. Other industry sources have reported 25% or more," he adds.

It's the flexibility of customization available to clients that is significant. If a client has strong feelings regarding social responsibility, the environment, or faith-based values, they can implement those beliefs through their portfolios. On the other hand, such restrictions may not be as important for many clients. But that doesn't mean the client might not change his or her mind a year or two later-restrictions can be placed or lifted at any time.

In the past, many managed accounts looked alike as a result of a limited investment style offering, usually large-cap growth or value. Customization may be more common today as international, mid-cap and small-cap styles are more commonly offered, allowing clients to take advantage of greater individualization regarding asset allocation and other investment options. 

Myth Or Reality: Managed Accounts Offer Individuals The Same Returns As Institutional Clients

Reality. Virtually all professional money managers start with a "model" type of portfolio that represents their best thinking, their best ideas and their best asset allocation at a given point in time. It's true that with managed accounts today, the portfolios of most clients will be somewhat similar or, in some cases, very similar to that model portfolio that the money manager has assembled. Sislen explains, though, that based on when a client buys into a portfolio or when the client invests with a particular manager, the portfolio can look different than another client's based on the tax preferences, restrictions and other preferences of that other client. So the model portfolio is only a starting point. Tax differences, security restrictions and other factors will create very different, or somewhat different, portfolios for clients.

But in explaining this to clients, advisors should emphasize that the difference in tax status of institutional accounts versus individual accounts can automatically make returns different, if only nominally.  If the dispersion among accounts is extremely dissimilar, that certainly would raise some questions that need to be answered. But in most cases, it can be explained by restrictions, by tax transactions or by the timing of the actual investment. "Differing contributions and withdrawals between the accounts also create dispersion," says Sislen.

Another good talking point for the dispersion among accounts is that institutional accounts, such as foundations and endowments, are required to distribute a certain percentage of funds each year; an individual's disbursement needs may be quite different based on, for example, the need for income or one-time expenditures.

Myth Or Reality: Returns Will Be The Same For All Investors Using The Same Manager

Myth. Clients could experience very different performance based on that extra dimension of management that an overlay portfolio manager (OPM) provides (as in a multiple-strategy account). One of the important things an overlay manager takes into consideration is tax differences from client to client, which can result in very different transactions from client to client. In other words, performance may vary because the transactions that occur in the particular accounts may vary. Clients' portfolios get personalized attention and custom strategies; therefore, Client A's account might not look the same as Client B's. 
    For example, let's say two clients open accounts-one two years earlier and the other eleven months earlier. The manager decides to sell out of a particular position that both clients own. The clients bought the position at the time each opened his or her account. The two-year-old client has a long-term position, so the manager sells it. The eleven-month client has a short-term gain, so the overlay manager might decide to hold that position for another month so it becomes a long-term position for the client. Even if there is a model portfolio involved, two clients could have different positions in their respective portfolios due to the level of service being provided. This is just one of the reasons performance and positions could vary with one manager.

Myth Or Reality: Fees For Managed Accounts Are Higher Than For Mutual Funds

Myth, generally speaking. Fees don't seem to be an issue for managed accounts today, according to both Owen and Sislen. "No one is paying 3% in fees anymore, and mutual fund fees have been steadily creeping up," says Owen. Managed account costs are the same as, or are lower than, mutual fund costs. Clients can negotiate fees, so fees can be different for every client.  Gloekner of Eastern Point Advisors says fees depend on the investment level. "Clients with larger assets can more easily negotiate a lower fee and can demand greater customization of services than clients with smaller assets," he explains.

If a client tries to make the case that an SMA costs just as much or more than the typical mutual fund, a good talking point is, "Assuming that were true, let's look at what you can get in an SMA that you can't get in a mutual fund.  What's that worth to you?  What's it worth that you can take additional tax losses this year in an SMA that you can't take in a mutual fund? And that's only one of the benefits."

The menu of services is custom tailored to the client and also to the advisor's particular style and way of doing business with those clients, says Frank Campanale, president of Michigan-based Campanale Consult-ing, former president and CEO of Smith Barney Consulting Group. "The fee may be higher for a client who requires high-touch service than for one who only wants to meet with the advisor once a year. An advisor's style and level of service may require him or her to spend more time providing customized service to fewer clients with larger assets," he says.

  "The point is," adds Sislen, "it isn't about fees, it's about what you get for that fee. The issue of fees is much more in the head of the advisor than it is a real issue with clients."

Myth Or Reality: Managed Accounts Are Great For Every Investor

Myth. They are not the right investment vehicle for every client-even if the client has the minimum amount of money necessary to open an SMA or a multiple-strategy account. "If a client is not willing to take at least a two- to three-year view, managed accounts may not be the right fit," says Sislen. "This is assuming the client has hired not just one manager, but multiple managers, which I believe can be the most appropriate way to invest in managed accounts.  In any one quarter of any given year, certain of those managers are going to under- or outperform other managers."

Some talking points for clients might include the following: Managed accounts are most appropriate for clients willing to delegate day-to-day management responsibility to a professional money manager. They also must be willing to have a highly diversified portfolio of securities. Many clients are used to having a concentrated portfolio, therefore having a highly diversified, large portfolio is not for everyone. Regardless of the possible benefits of such a portfolio, some clients would rather be more aggressive and take more risks with a more concentrated portfolio. 

Dispelling Myths

Education can prevent or eliminate myths surrounding managed accounts and help clients take advantage of the benefits they afford. Campanale and Sislen both agree on having some basic points to discuss with your clients so misunderstandings don't take hold.
Here are a few:
    1.) Even with the low minimums now available, every client is not a candidate. Tell them how managed accounts operate, look at their needs, then make the decision.
    2.) Discuss the advantages of why it is important to take a long-term view.
    3.) Explain that in any short period of time, a manager might underperform the benchmark, index or mutual fund, so a short-term worrier is not a good candidate, nor is an aggressive investor with a concentrated portfolio.
    4.) Discuss fees openly and show comparisons to other vehicles.
    5.) Explain your process and how SMAs fit into your practice.

According to the experts interviewed, there needs to be a serious commitment on the part of the advisor to properly explain and deliver these services. The advisor must be a consultant and understand that education is a continuous process. Otherwise, myths and misunderstandings will proliferate, they say.

Don't allow clients to conjure up misinformed ideas about investment solutions that might damage their overall impression of your service, as well as their portfolio's performance.  Be a hit, and stop the myths.

The author thanks Mr. Sislen for his assistance in providing the additional research for the article. We also congratulate Mr. Owen on his latest book, Cowboy Ethics: What Wall Street Can Learn From the Code of the West.