Are they strange bedfellows-or pillow talk?

    Separately managed accounts (SMAs) have taken on a broader definition over the past few years. They used to be known primarily as an account run by a portfolio manager in which the securities are owned directly by the client instead of being pooled into shareholder units.
Now they can mean anything, from an entire basket of different separate account managers (MDA, MSA, MSP, etc.) to an account also holding mutual funds, cash, and exchange-traded funds, or ETFs.
    Of these companion investment vehicles, ETFs are proving to be one of the most popular. Take, for example, the recent growth numbers of the Select Sector SPDRs ("Spiders"), which slice and dice the S&P 500. According to State Street Bank's Greg Ehret, assets under management in Select Sector SPDRs had increased approximately 26% to almost $12 billion as of June 30.  
    Why are ETFs becoming so large a part of the investment landscape and how does their use complement an SMA portfolio? Let's explore possible answers to those questions, as well as take a brief glimpse into the future of ETFs and what that future may mean for advisors who use SMAs for their clients.

The Ingredients Of ETF Popularity
    The recent regulatory difficulties faced by the mutual fund industry have fed the growth of SMAs. The latest Money Management Institute figures place that growth at 12.5% in the first quarter of 2005 compared with Q1 2004. Total industry accounts increased by 31% in 2004. But often, advisors find it difficult to implement a robust allocation for smaller investors. Because of their breadth of market exposure and ease of use, ETFs have become the complementary vehicle of choice.
    Their advantages are diverse-they have lower costs because of their management structure; they are more tax efficient because of the lower turnover characteristic of passive management and the mandate of the ETF structure to avoid throwing off capital gains; and there are now ETFs to cover practically any industry sector or asset class, including emerging markets and real estate. In short, since ETFs can be found that track practically anything, they can be the perfect complement to an SMA strategy.
    ETFs have multiple characteristics that lend themselves to living compatibly with SMAs. According to Valerie Corradini, senior strategist at Barclay's Global Investors in San Francisco, ETFs' popularity can be attributed to something different. "When you start talking to consultants who are using SMAs and they learn the breadth of ETFs, their eyes light up because they can implement strategies in ways that didn't exist five years ago. This isn't just a product. This is a whole new opportunity set for index investments, alongside the active managers they're hiring," explains Corradini. "For example, five years ago when SMA minimums were still around $100,000, it was difficult for an investor with $250,000 to get proper diversification using only SMA managers. With the broader access to almost any asset class or industry sector using ETFs, it's much easier to round out allocations for such clients."
    Says Ron Pruitt, chief investment officer for Placemark Investments in Wellesley, Mass., "When you look at the asset size a client has to invest, you can't really get a 7.5% allocation to small-cap growth or a 10% allocation to international with a $250,000 client. Even though we've been able to get smaller minimums from SMA managers through Unified Managed Accounts (UMA) accounts, you don't want a $250,000 portfolio with 500 securities in it."
    Another problem with small- and mid-cap exposures is the limited capacity of SMA portfolios in these asset classes. "SMA allocations for small cap are always difficult to fill because the managers get to capacity so quickly," continues Pruitt. "Small-cap products generally have a billion to billion-and-a-half capacity-the wirehouse distribution alone can eat up half of that in no time. ETFs offer exposure to such asset classes without capacity concerns, allowing smaller investors to have a more robust allocation than they might otherwise."
    Corradini broadens the allocation "rounding out" feature to include exposure to the Morgan Stanley EAFE index or the Russell 2000 growth index, exposure to each of which can be obtained through a single security. A second asset allocation problem solvable by using ETFs occurs when advisors terminate a manager, or a firm decides to restrict a manager on the approved list to new assets. By using ETFs, "they're able to maintain the integrity of the asset allocation and be fully invested according to their master plan without being pressed to find a new manager to fill the investment in that category," says Corradini. Advisors can park the funds from the restricted manager's account in an ETF representing the same asset class or strategy, buying time to research possible replacements while avoiding imbalance in the portfolio's exposure.
    All-inclusive platform structures for both wirehouse and independent advisors have also strengthened ETF popularity. Before the user-friendly UMA-type structure, advisors would have to place SMAs in a fee-based account and place ETF exposure to asset classes like small-cap and international equity in a separate brokerage account.
    "So, it was difficult for them to do holistic planning because the client would get two different statements and the advisor would have to reconcile them by hand. The brokerage firm statement would just list the position and its value on the last day of the month-it didn't calculate performance like an SMA statement. But as ETFs have proven they're here to stay, platforms have adapted as well," Corradini adds.

    As ETFs have grown in popularity, so have the strategies advisors use in deploying them alongside SMAs for the benefit of clients. The specific strategies used to round out asset allocations using ETFs vary among advisors, but we'll discuss several of the most popular.
    Most portfolio strategies stem from the asset allocation component and are driven by various factors. It is within this context that ETFs show their greatest advantages. Asset allocation strategies generally are based on clients' risk tolerance and investment objectives.
    Within those generalities lie customized options. For example Drew Washburn, CEO of Washburn and Fisher Investment Consulting Inc. in Parker, Colo., begins with an optimization process designed to follow market trends. "We use ETFs for allocations where we believe an active manager really can't add a lot of alpha right now. Currently, that means using ETFs to set up a core portfolio exposure to large-cap growth and value, then selecting satellite active managers to fill out the allocation," he explains.
    Washburn adds that the strategy can change according to market cycles, but the strategies employed are governed by a combination of the optimization model and what they see happening in the market. Another part of Washburn's strategy is to use ETFs to add negative correlation component to manage risk. "We've found that some of the indices [to which we gain exposure through ETFs] have a pretty substantial negative correlation to our satellite active managers, which benefits the whole portfolio," he explains.
    The increasingly popular core and satellite strategy can also work the other way around. A client with smaller assets can choose an SMA to fulfill the core allocation and use ETFs to fill out the allocation with exposure to small cap, mid cap, EAFE, emerging markets, or other asset class exposure.
    The second most strategic use for ETFs involves tax management. Pruitt offers this example: "We usually use an overlay approach for tax-efficiency, but perhaps a client only wants to harvest losses. In that case, you're left with a choice. You either sell your losses and wait 30 days in cash so you're losing your capital market exposure, or you can invest into other securities in the model or alternates the manager may possibly provide, or you can substitute an ETF for the exposure and buy back into the security after the 30-day period."
    A similar challenge occurs with a security restriction. "At some point, if I overweight all the other stocks in my portfolio because of the restriction, that restriction is going to have to be unwound. With an incremental ten to 15 trades incurred with every account that has restrictions, a sponsor is faced with the challenge of deciding how many restrictions can he allow if it involves all these little trades."
    If the restriction happens to be a small-cap or mid-cap stock, the costs to the client are also higher. Spreads in those securities tend to be wider, potentially adding a number of embedded costs to the client with the execution of so many small trades. "ETFs tend to have very narrow spreads compared to small-cap, mid-cap or international stocks, so I can trade into those and avoid the drag on the performance of the account associated with wide spread securities," explains Pruitt.
    ETFs can also be used as hedging instruments. They can be optioned, margined and shorted. According to ETF pioneer and developer Gary L. Gastineau, a managing member at Summit, N.J.-based ETF Consultants LLC, the short interest in ETFs tells the real story behind their popularity. "The interesting thing is the short interest in the typical ETF is about 20% of the shares outstanding," says Gastineau. "As of year-end 2004, total ETF assets were reported at $226 billion. If you add the short interest, it's 20% higher. So in effect, there are a lot more long positions in ETFs than have actually been issued, which means they're even more popular than they get credit for."
    As Washburn mentions above, some ETFs provide a natural hedge through their low correlation to other securities in the portfolio. Tactical asset allocators, however, may find ETFs an easier venue through which to create portable alpha, according to Pruitt. "ETFs create a marketable vehicle for an index that can be shorted via an option. It's certainly more available (than index options)."

Other Advantages
    ETFs can also add stability to an overall portfolio, depending on the desirability of combining active and passive management based on market conditions. During the late '90s, indexing became quite popular as active managers found it increasingly difficult to beat the market. But in the current environment, a 'stock picker's' environment, according to Washburn, the combination of the two may be more attractive.
    According to Rick Brooks, CFP, CFA and portfolio manager at Blankinship & Foster Family Wealth Advisors in Del Mar, Calif., larger investors ($10 million to $15 million) can use ETFs to provide an easy way to overweight a particular style or sector quickly. "That's not something an SMA manager is really going to be able to do," explains Brooks. The ability to move funds around within an SMA account can be accomplished quickly by using ETFs since they are traded on the exchanges like stocks but add multiple exposure through a single security.
    What's the downside?
    With all of their advantages, ETFs do have disadvantages of which advisors must be aware. "ETFs are a closed-end product and they can trade at a discount to the underlying securities," offers Pruitt, "and for some of the benchmarks that are challenging to use such as fixed income, the ETFs don't necessarily track them well."
    And, although small, there are management fees on ETFs, creating a 'below-the-line' expense that must be disclosed to the client, according to Pruitt. Washburn alerts advisors to the fact that, since ETFs trade like stocks, their valuations must also be considered, just as with stocks. "The market maker's making money, so if you're paying too much of a premium for the ETF, it may eat into the value-added on the performance side, even though ETF costs in general may be very low."

    The future for ETFs looks bright at this point. Regardless of market cycles and whether active or passive management should be used, the popularity of ETFs likely will increase simply from an increasing breadth of product/exposure availability.
    For example, Pruitt predicts that ETFs will be created that offer exposure to specific fixed-income durations, allowing investors more customization in asset allocation. Gastineau cites the work already being done to create commodities and managed futures ETFs, which will offer clients easier access to commodities and futures products, and, again, allow investors more robust allocations and enabling better risk management.
    The increasing versatility and breadth of ETF offerings promises to sustain them as a valuable complement to the SMA consulting process. The ability to use ETFs to increase the customized allocations and tax management fostered by the SMA process will only serve clients better going forward. 

Financial writer and veteran wealth manager Lisa Gray assisted with the research and interviews for this article.