Is now the time to re-think fixed income vehicles for your clients?

Concerns about municipal bond credit quality arising from the recession and the historically poor condition of state and municipal finances are driving an increasing number of advisors to look at alternatives to traditional bond mutual funds for their clients. Small states are suffering the worst from the federal spending cutbacks, since larger states have larger budgets and can weather such cuts more effectively.

Possible rating agency downgrades in the bonds of vulnerable states recently spurred a decision by the Coral Gables, Fla., wealth management firm of Evensky, Brown & Katz to switch their clients from municipal bond funds to separately managed accounts from Nuveen, Thornburg and Neuberger Berman. We caught up with Harold Evensky and asked about his firm's decision-making process, as well as his thoughts on the advantages of working with separate account bond managers.

Says Evensky, "We're not concerned necessarily that if we buy a AA bond that it's going to go broke, but we can see downgrades. We're in bonds to help clients preserve principal and sleep well at night, not to have to explain to them, 'Oh, don't worry, the price dropped because it was downgraded, but you're going to be okay.'"

Evensky says that today's bond market is extraordinarily complex, so they monitor credit quality on a daily basis. "Our policy traditionally has been to buy high quality and forget it, but we no longer think that's necessarily wise." Evensky states that using separate account managers has been prohibitively expensive in the past, but the technological developments of the past few years now enable the firm to "cut out the middleman" and offer separate accounts at reduced fees. He says that even 1% is too much to manage a municipal bond portfolio, "but now we can access high-quality managers in the range of 35 basis points. They can buy cheaper than we can, add some value through active credit management, and more than cover their costs."

FA: Are the managers charging less?

Evensky: The "brains" have probably always gotten around 35 bps, while all the bells and whistles added by the middlemen tacked on up to another 115 bps. Our frustration was that we were paying so much, and so little was going to the intellectual capital.

FA: So you're able to deal directly with the manager thru the SMA?

Evensky: Right. We can open an account and give them limited discretionary authority. We do our own due diligence now, so we don't need the fancy reports and their due diligence. We just want the brains.

FA: Are you telling us that you're cutting out the extra fees by coming out of mutual funds or by going to SMAs?

Evensky: Both. In our larger accounts, we used to purchase our own bonds. We'd design our own maturity ladders and had our own quality and other criteria, but once we bought in, we held. Now, we can get active management using some of the same managers we used at the mutual funds, only we deal with them directly, and we get them cheaper than we could by buying their fund.

FA: So how does going with an SMA manager help with the credit quality problem?

Evensky: Since we do our own due diligence, we're able to select managers who are willing to customize according to our criteria. One manager is a pure ladder manager, others are more flexible, but all of them work on a laddering concept. Historically, our ladder has been zero to ten years. Now, we're cutting that back to eight years. Our durations used to be four-and-a-half years, now we've cut those back to three-and-a-half. We're also doing it for corporates-the same issues hold in corporates.

FA: When did all of this become a concern for your firm?

Evensky: Within the past year, our firm has had serious concern about the credit quality of bonds. There is an increasing quantity of new bond issues and greater concern about quality. But two things sort of came together-our ability to access the managers directly plus the growing concerns about credit quality. We think returns in general are going to be pretty low across the board for stocks and bonds, actually bonds a little higher than the historical average and stocks a little lower. The most important things going forward will be preservation of capital and tax and expense management. As a result, we're moving more toward ETFs and separate account management.

FA: What about the richness of the bond market, though?

Evensky: We've never believed in making an interest rate bet. We certainly think the bond market is rich, so that's why we've adjusted our ladder and our durations. We start with a laddered portfolio, maybe with a slight barbell or a slight adjustment, but we always begin as a default with a laddered portfolio. The richness of the bond market and our credit quality concerns caused us to shorten.

FA: So the SMA managers you're using are adjusting their durations for you as well?

Evensky: Well, we're managing that, subject to discussions with them. We've been careful to select managers who will work with us and customize to our criteria and parameters.

FA: What's the ultimate value in your view in choosing an SMA over a mutual fund?

Evensky: By doing our own due diligence and dealing with the managers directly, we can get active management cheaper and more customization.

FA: Thank you, Harold, for your explanation.

Lisa Gray, CIMC, is a Memphis, TN-based financial journalist and consultant who assisted in the writing of this article.

Research Predicts SMA Pricing Model Changes

Innovations in services and products are also anticipated.

By Sydney LeBlanc

In 2002, assets in separately managed accounts held steady while the assets in mutual funds declined. By last October, mutual fund assets were down 8% while separately managed account assets were down only 1.4%. Part of the reason is that separately managed accounts are aggressively being introduced in the independent advisor markets, giving them more fuel to move ahead.

Another factor is that brokerages and custodial service providers continue to expand and develop various types of fee-based programs, and the number of product offerings will continue to grow. These investment vehicles are likely to expand more creatively; for example, several firms already are building wraps around exchanged-traded funds and folios.

To further explain how fee accounts and SMAs will prosper, Tiburon Strategic Advisors in February released an updated version of its 305-page report, "Fee Accounts, TAMPs, and the Booming Separately Managed Accounts Market." For purposes of this article, we have distilled portions of the report and will focus on their predictions for, and expected innovations in, the following areas:

A. Pricing Models

B. Wealth Management Accounts

C. Other Innovations, including MDAs, Altern-atives and Packaged Products

Pricing Models

Commission Models: Over the past decade, the industry has promoted fee-based business as the answer to commission-based conflicts of interest. Curiously, one of the pricing model predictions is centered around commissions. We may see some fee account programs with contingent deferred sales charges, which could include charges of 3%, 2% and 1% over three years. This would appeal to those advisors and brokers in transition from fees to commissions. An advantage to clients would be the gradual introduction of fee accounts for those not yet fully engaged, or who just want to take it more slowly. The report suggests that a blending of fee and commission models may be emerging as well.

Chip Roame, managing principal at Tiburon, clarified these findings saying, "There are two points here:

1. Some firms may create fee-account programs whereby the client is charged a CDSC for exiting early. These will be especially valuable to protect the economics of the advisor who invests his/her time substantially upfront and then may see a client exit after six months, having only earned half of one year's fee (maybe as little as 50 basis points).

2. A distinctly different approach-some firms may offer to pay advisors a commission-like upfront sum for the sale of fee-accounts while still collecting traditional fees from the client. In other words, the firm would subsidize the advisor upfront and collect later from the client. This would. be especially useful to the advisors used to the 4% to 5% upfront commissions."

Retainer Models: This model may work better for clients whose needs are more far-reaching than simply investment strategies. Fees on assets could be at least partially displaced by retainers in this instance. The aging baby boomer population could create this next sea change. Some in our industry have argued that some asset-based fees are now causing, or have the potential to cause, conflicts of interest. As an example, diversifying into real estate or making a larger-than-needed home downpayment might be discouraged by an advisor collecting an asset based fee. The client's best interests would not be served in this case. Tiburon suggests that the more affluent client would likely benefit by the retainer fees, and that firms using this model would draw more members of this audience as a result.

Unbundled Offers: Even though the much-debated concept of process vs. product continues to rage on, the industry at large has accepted the consulting process as valuable for small, mid and large investors. The products are the interchangeable vehicles, and methods of delivery. Tiburon suggests that client profiling, asset allocation and the investment selection should remain bundled; however, the re-allocation of assets, quarterly reporting, monitoring of the manager(s) and continuing client service that the industry assumes as part of the "wrap" services could be unbundled for separate pricing. Separating the money management, custody, and clearing fees also may make sense. These costs, plus the administration fees, are all grouped in the proprietary programs; while many firms already unbundle on a case-by-case basis. Tiburon says unbundling the trading costs might be good for those who are subsidizing others.

According to Roame, unbundling trading costs would benefit clients who chose low turnover managers. Says Roame, "Some managers have very high turnover [many trades]. As a result, pricing schedules must take this into account, and hence, clients using low turnover managers are paying more than they should. Unbundling trading costs would allow these clients to pay less."

Is The Wealth Management Account Around The Corner?

Since wealth management is gaining in significance for investors, it is likely that firms could soon introduce a wealth management account that bundles fees for certain services. For example, tax, insurance and estate planning would be included in one account along with investment management. According to Tiburon, many of the report participants liked the concept, and one firm, Legg Mason, currently is executing a similar program.

Again, the goal would be to include all investors in the consulting process. For example, if the process was wrapped around various investment vehicles, clients would benefit both on the fee side and on the services side. For smaller clients, mutual funds, exchange traded funds and annuities could be the core products; mid-sized clients would receive institutional funds and MDA-type vehicles. The affluent client may require separate accounts and alternative investments such as hedge funds; the ultra-high-net-worth individual may seek institutional investing consulting, insurance packaging, and wealth management services.

Customizable MDAs and Other Investment Vehicle Innovations

The MDA-type accounts (pioneered by Citigroup in 1997) should gain considerable momentum over the next few years, according to the Tiburon report. They also may be customizable. Currently, convenient off-the-rack asset allocations are offered, but with new entrants the industry may see the overlay process pulled in-house. The goal is to create completely customized portfolios.

So far, the major MDA-type account successes are proprietary products in proprietary channels (such as Merrill and Smith Barney), but the dynamic models will be the product design of choice and could emerge as soon as this year.

The MDA-type accounts already have evolved through three generations of models:

1999: Pre-defined models with single proprietary managers. These programs lacked any third-party managers, multiple managers or customization capabilities.

2001: Pre-defined models using single third-party managers. These programs used third-party managers, but only one, and were not customizable.

2002: Pre-defined models using multiple third-party managers. These programs now use multiple third-party managers, but are not yet customizable.

The design of this new model should help speed the growth of the entire MDA market. Tiburon estimates $50 billion in annuals sales by 2004, growing to $250 billion by 2007.

Insurance Packaging: As mentioned earlier, the high-net-worth individual may have the option of choosing a fee account with an insurance wrapper. Both insurance and investment companies are developing products which can be wrapped around both SMAs and mutual fund wrap programs.

Unified Managed Accounts (UMAs): According to Roame, the ultimate vehicle should be an "open fee" platform allowing assets to be priced individually. "There is no reason why investors should have to have different accounts for various assets they own." The report suggests that an investor could utilize separate account managers, various mutual funds and individual securities in the same account. Some firms already provide UMAs for their ultra-affluent clients in the private banking arena, with accounts starting at $5 million.

These emerging developments, plus technology and distribution opportunities (including international), bode well for fee business and SMAs over the near term. Tiburon's report also points out that as the independent markets grow and the discount brokers move up-market, the long term possibilities are significant. Says Roame, "It's an exciting time for the fee-accounts industry."