Justifying fees on SMAs, mutual funds and advice.

The separately managed accounts (SMA) industry has shown strong growth in recent years, but this growth is actually driven by a relatively small number of advisors. Why are so many advisors still standing on the sidelines?

One reason is fees. There is a perception among many advisors that SMAs are expensive, and that they "just can't justify the fees." Certainly clients are very sensitive to the fees they pay these days after experiencing several years of negative returns and significant portfolio losses. But I find that many advisors who have objections to SMA fees do not truly understand them or how to compare them with other alternatives. So let's take a look at what SMAs really cost.

You Get What You Pay For

Let's examine the range of fees that a client might encounter in the market today for a $250,000 SMA. Of course, there are many SMA programs available, and each has its own unique cost structure, so our analysis should be viewed only as a general guide.

There are four components of the typical SMA fee. The first component is the manager's fee. For a domestic equity account the fee is likely to range between 40 and 60 basis points (there are outliers on both sides). Fees for fixed-income managers usually range from 25 to 35 basis points. The most obvious service covered by the manager's fee is day-to-day portfolio management by a professional money manager. But the manager's fee also covers services such as customizing a client's portfolio, harvesting tax losses at year-end and providing various "value-added" services designed to help an advisor provide better service to his or her clients.

The next component is the program sponsor's fee. The sponsor's fee typically ranges between 25 and 50 basis points. The sponsor's fee covers a range of services, including ongoing manager due diligence, assistance with asset allocation and investment strategy development, periodic performance reporting, portfolio accounting, account reconciliation and a range of tools and services. SMA "supermarkets" such as Schwab's Managed Account Marketplace are starting to emerge, and these programs do not charge a sponsor fee. But SMA supermarkets do not provide many of the services associated with traditional SMA programs, such as due diligence and performance reporting. Instead, they simply provide advisors with access to managers.

The third component is the fee for brokerage and custody. In most cases brokerage is not charged on a transaction basis, but is covered by an asset-based fee that includes custody. Together brokerage and custody fees are likely to range from 25 to 35 basis points.

The final component is the fee paid to the financial advisor. The advisor's fee for a $250,000 account is usually about 100 basis points. This fee covers the ongoing advice and consulting services provided to the client by the advisor.

So the formula for understanding SMA fees is: Manager's Fee + Sponsor's Fee + Brokerage and Custody + Advisor's Fee = Total Cost. In some programs these fees are not set forth separately, but are aggregated or "wrapped" together. In such cases, it is difficult to tell how the fee is being allocated. In other programs, the fees are "unbundled" and stated separately so it is easy to tell how much of the fee is going for each service. Either way, the total fee paid by the client is the same.

So what do you get when you add it all up? Well, theoretically, you get a range of about 190 basis points on the low side and about 245 basis points on the high side for a domestic equity account. But, in practice, the actual cost of a $250,000 SMA usually falls somewhere in the 200-225 basis-point range. Even at the wirehouses, where the published fee schedule may be as high as 300 basis points, fees are very often discounted to fall somewhere within this range.

So are SMA fees too high, or are they reasonable given the services they cover? If you are still unsure, maybe a comparison with some of the alternatives will help you with the justification that you need.

The Cost Of Mutual Funds Vs. SMAs

Most of the advisors I have spoken to who "can't justify the fees" associated with SMAs develop portfolios for their clients using mutual funds. Some use mutual fund wrap programs, and some take a do-it-yourself approach: selecting funds, constructing portfolios and producing performance reports themselves. In comparing these alternatives to SMAs, it is very important to make sure that the comparison is done on an apples-to-apples basis. Many comparisons I have seen are not.

Let's look at mutual fund wrap programs first. There are four components to the cost of these programs that roughly equate to the four components of the SMA fee. The first is the expense ratio of the funds that are used in the program. The expense ratio covers the cost of investment management and certain other fund expenses. The average expense ratio for a domestic equity fund is somewhere between 125 and 145 basis points. Of course, there are outliers on both sides, just as there are with SMAs.

The next component is the program sponsor's fee. Sponsor fees for mutual fund wrap programs typically range from 20 to 40 basis points, a bit lower than for SMA programs. In some cases the sponsor's fee is buried inside the fund expense ratio and is not broken out separately. But be assured, whether you see the fee broken out separately or not, the program sponsor is being paid for its efforts.

Investors who use mutual fund wrap programs also pay for brokerage and custody. The cost of brokerage and custody usually falls in the 10-to-25 basis point range, in the aggregate. The first part of this cost consists of brokerage costs incurred by the funds when they purchase and sell securities. This cost can be hard to determine because it is never shown on a program's fee schedule and is not even included in the fund's expense ratio. But a fund's brokerage expenses are an actual cost to the fund's shareholders. Custody charges are usually easier to determine because they are often stated separately in a program's fee schedule and are visible on the client's monthly statement.

As with SMA programs, advisors are usually paid around 100 basis points for their services in connection with a $250,000 mutual fund wrap account. This fee covers the advisor's ongoing advice and consulting services to the client.

How do these expenses compare with the cost of using SMAs?

Well, using these figures, the total cost of the typical mutual fund wrap program would range from 255 basis points on the low side to 310 basis points on the high side. The fact is, however, that most mutual fund wrap programs use funds that have below-average expense ratios. For this reason a fairer range is probably somewhere in the area of 215 to 250 basis points.

But wait! That means that the cost of using a mutual fund wrap program may be about the same, or maybe even a little higher, than the cost of using an SMA. And the SMA has customization, tax and transparency benefits that mutual funds don't offer. Maybe SMAs aren't so expensive after all.

Now let's compare them with the cost of the do-it-yourself approach, where the advisor builds the mutual fund portfolio herself and there is no program sponsor to pay. If we subtract the sponsor fee from the equation and continue to use the average fund expense ratio, the total cost of using mutual funds ranges from 235 to 270 basis points. If we use a lower expense ratio, say 85 basis points, and assume a low brokerage and custody cost of 10 basis points, the cost of the do-it-yourself approach might be as low as 195 basis points. But a more realistic brokerage and custody fee is probably in the 15 to 20 basis point range, putting the cost of the do-it-yourself approach closer to 200 to 205 basis points-about the same as using an SMA. And the advisor using the do-it-yourself approach doesn't get any of the services that the SMA program sponsor provides.

So What's The Point?

The point of this exercise is not to prove that SMAs or mutual funds are superior to the other based on price. Rather, the first point is to give you a framework for comparing SMAs to other investment vehicles on an apples-to-apples basis. You can plug your own variables into the equation, but I think you will find that most SMA programs are reasonably priced relative to the alternatives.

The second point is to underscore that any cost comparisons should take into consideration the characteristics of the product and the services that come with it. For example:

How much is the ability to customize an SMA worth to your client?

How much is the ability to do tax loss harvesting worth?

How much are the due diligence and performance reporting services provided by an SMA program sponsor worth?

I believe that SMAs and mutual funds are pretty close in terms of their cost to the investor. But if you believe SMAs are a bit more expensive after you plug your numbers into the equation, consider whether the extra cost is justified based on product characteristics.

Also keep in mind, when considering the relative costs of SMAs and mutual funds, that the costs associated with SMAs tend to be more transparent than those associated with funds. Expense ratios, brokerage costs and sometimes even program sponsor fees are embedded within the mutual fund structure and are not readily apparent to investors. SMA expenses, whether they are "wrapped" or "unbundled," tend to be more visible because they are specifically disclosed to clients in a separate fee schedule.

By Scott A. MacKillop

Lurking in the midst of this discussion is an even bigger issue: how you justify the fees you charge your clients. The move from commissions to fees is driven by something far bigger than how advisors are compensated. It has to do with a fundamental shift in the nature of the services that are provided to clients and the manner in which those services are delivered.

Ideally, fee-based services should be delivered through a consultative process that focuses on understanding and satisfying client needs. The process does not end when a product is sold to the client. That is just the beginning. Fees are not an alternative source of compensation for a product sale so much as they are an ongoing charge for ongoing services provided. Fees support the cost of a continuing relationship with the client through good times and bad. You cannot guarantee your clients continually rising markets and positive performance. You cannot provide them with quick fixes or instant remedies for the losses they have suffered. That is not what your clients are paying you for. They are paying for your best ongoing advice and objective guidance through up and down markets.

If you are having trouble justifying the fees associated with SMAs, mutual funds or other products you may have sold your clients, ask yourself this: Have you taken the time to explain to your client what the fee they are paying is really for? If you have, and the client is still not satisfied, ask yourself this: Have you and the others who are receiving a portion of the fee (managers, sponsors, custodians, etc.) delivered the level of ongoing advice and service the client should expect for the fee they are paying? If they have, justifying the fee should be a lot easier, regardless of the products you use.

Scott MacKillop is president of Trivium Consulting, which provides consulting services to managed account sponsors and money managers. He can be reached at [email protected].