Separately managed accounts (SMAs) have been touted as the Holy Grail of the investment industry-the wirehouses certainly bear witness to that premise. But what's the story for independent advisors?

Financial Research Corp. (FRC) found in its 2004 study, An Overview of the Separate Account Industry, that 30% of its independent advisory sampling incorporated separate accounts into their businesses. Further, SMA business constituted a mere 10% share of that sample's total. Compared with the wirehouses' 70% market share overall-not just within a sampling-separate account use by independent advisors appears paltry. Yet, industry experts cite the independent advisory market as the fastest-growing SMA market today.

Despite these statistics, independents are slowly but steadily increasing their use of SMAs. Their slow acceptance could be due to one or more of the following considerations:

Relative newness of the product to this segment.

Time required for advisors to properly educate themselves about SMAs.

Time and education required to learn the cons ulting process.

Complex operational and administrative requirements.

Requisite addition of staff and the budget needed.

Additional training of that staff.

Implementation of complex fiduciary activities, including conducting adequate due diligence in the manager search, selection and monitoring process.

In fact, the due diligence alone, if implemented properly, is enough to make many advisors' heads swim. This article will explore what advisors should know about proper due diligence, how they are implementing it, and some of the tools available to help them fold the process into their businesses in a more streamlined fashion.

Nuts And Bolts

The process of conducting adequate research on money managers-comparing performance, business practices and processes, determining the right managers to implement the asset allocation and making sure those managers are a "good fit" for the allocation-involves a multitiered process. As an advisor's clients gain wealth, the process becomes more complex.

The challenge for independent advisors is to find access to the same extensive research information that wirehouse advisors get. Such access can be limited by operating budgets, locating the best resources and hiring additional staff to manage the resources within the advisor's practice. Up to now, advisor due diligence tools have been limited, but new platforms are being developed that encompass more of what they need in one offering. As these new platforms continue to develop, advisors will be able to streamline this and other areas of the SMA consulting processes, making the SMA business more attractive.

But What Services Do They Need To Access?

First, a basic list of due diligence process components needs to be identified. Bare bones due diligence involves looking at three primary areas of a manager's operations: philosophy, people and process. Some of the areas that must be researched include (among a plethora of other things) the examination of a manager's:

Trading system

Operations and administrative functions

Fee structures

Possible conflicts of interest

Management style

Marketing materials

Business plan

Management of market instability

Flexibility

Technology platforms

Performance reporting, including how portfolios are weighted, and benchmarking comparisons

How the manager's costs impact investors' returns

Examining these items alone can prove a daunting task, much less having to conduct deeper research on more than one manager if multiple managers need to be hired. How can advisors accomplish this examination and still have time to run their businesses? Are there alternatives to doing the due diligence themselves? How do advisors feel about the arduous process, and what methods do they use?

Matthew Potter, CIMC, CFP, a planner with Raymond James Financial Services in Cheyenne, Wyo., says, "Some advisors see an SMA as a new venue for their business and they treat it as a commodity, selling it like a mutual fund rather than using it in the context of a consulting or advisory process. These advisors simply consider the due diligence part of the product offering without examining the qualitative or quantitative factors to be considered. They follow the format indicated by their money manager selection resource, use one of a few preset asset allocation models-the closest fit for the answers on the client profile questionnaire-and produce a mix of managers from the list provided, comparing performance with other managers on the list."

Some advisors maintain their own manager databases in addition to the ones provided by either the broker-dealer firm through which they operate or the third-party platform. It can prove to be an expensive, time-consuming process simply to manage the database, much less to examine each manager on whom data is collected. But, many higher-level advisors and investment management consultants, particularly those veterans holding the CIMA and CIMC designations, enjoy the due diligence aspect of the investment consulting process and feel it adds value. If an advisor chooses to do his or her own manager search and evaluation, for example, here is what advisor and consultant Richard M. Todd, CIMC and principal with Innovest Portfolio Solutions in Greenwood Village, Colo., offers as guidance:

"Our own manager research process is driven by three primary goals: 1. Identify managers with a proven ability to produce alpha; 2. Understand a manager's risk exposure and sources of return in a manager's investment strategy (does a manager's philosophy, process and performance attribution align properly); and, 3. Determine if that alpha generation is sustainable. Are there outside factors, in particular, that would disrupt this success?"

Todd has five key questions he uses to successfully evaluate the managers he uses:

1. Does the manager (or team) have exceptional insight, work experience and/or academic success?

2. Does the manager employ a unique strategy that can capitalize on market inefficiencies (perhaps as a result of their intellectual edge)?

3. Does the manager have more firepower in terms of total experience, number of professionals, or systems?

4. Does the manager have better access to information than does his or her peers?

5. Does the manager have superior trading skills or systems that can enhance performance?

By and large, these questions can identify key facts that explain past performance (positive or negative) and, more importantly, can help provide a sense of whether a manager will be able to add value going forward. "If an advisor is doing the due diligence, then a complete organizational analysis must be completed as well," says Todd. Firms with superior back-office capabilities, low personnel turnover, independent firms with few conflicts of interest and firms with plenty of "skin in the game," as well as those with a specific specialty, attract Todd's attention.

Portfolio construction is a vital element to consider, as well, in the advisor's own due diligence effort. Todd emphasizes that it is imperative to understand the role of each manager in a portfolio before a manager search even begins. It is certainly possible for an investor to have an array of very talented managers, he says, but if the fit is awkward, total portfolio performance can be mediocre; for instance, deep value managers complemented by aggressive growth. "We saw many large stock portfolios in the late '90s comprised of an aggressive growth manager and a relative value manager. As the market tumbled in 2000-2002, the value manager was not nearly as defensive as the investor had hoped, and the portfolio was punished."

The process Todd explains may sound daunting, and many advisors will opt for outside expertise as a result. New platforms are being created that provide greater depth to due diligence and research services, and allow advisors to eliminate some of the tremendously time consuming work that needs to be done. Other third-party sources are teaming up with strategic partners to offer advisors more complete due diligence services, and explain the process they go through so the advisor knows the quality of the process and is able to better determine the appropriate fit with their clients (see accompanying sidebar).

How Deep Should Due Diligence Go?

The depth of due diligence performed is an important factor in advisors' responsibilities within the consulting process. "I would certainly advise other advisors to have their own due diligence process in a documented fashion," says Potter, "because you never know when it's going to end up in front of an arbitrator as to how you made this particular selection. In fact, if you look at it from a fiduciary standpoint for a foundation or a qualified plan, that's really the basis of arbitrator or court challenges-the question is, not what you came up with, it's how did you come up with it?"

That could be a sticking point for advisors commoditizing SMAs as just another product. For this reason, Adam Westphalen, CIMA, with Vista Financial Strategies, a division of United Planners Financial Services, stresses the importance of advisor education, preferably through a program like the Certified Investment Management Analyst (CIMA) sponsored by the Investment Management Consultants Association (IMCA). "Such an education provides the capability for advisors to conduct the due diligence process on their own if they want to and, more importantly, to better determine the quality of due diligence research they are getting from vendors," says Westphalen.

The Aid Of Technology

"You've got to spend some money on the technology and be willing to take the time to learn how to use it," says Potter. "There's so much information to read, and you do have to be willing to take the time to understand and learn first-you can't just expect to do this business overnight. It takes time and commitment."

The ongoing development of technology platforms and tools simplifies the SMA adoption process, but it also creates scalability of solutions and reduces formerly prohibitive fees on smaller asset sizes. Just a few years ago, the scant platform offerings were turnkey solutions provided by such well respected firms as Lockwood Advisors Inc., Brinker Capital, ADVISORport and EnvestnetPMC. They focus on providing functions allowing independent advisors access to client profiling, proposal generation, asset allocation choices-usually from preset models-and a slate of managers from which to choose.

Today, even simpler platform-like services are being offered by such firms as Morningstar, which simply track manager performance. This service is valuable for advisors who are searching for and evaluating information for their own database of managers, because it offers performance information for advisors to use in their due diligence process. However, proper due diligence requires more. "The challenge with (manager performance tracking services) is you're dealing with information that may be 90 to 180 days old," says Westphalen. The added benefit of working with an outside source is that advisors can spend more time hand-holding and supporting the client, according to veteran consultant Barry Mendelson, CIMA, AIFA, founder and managing director of Capital Market Consultants LLC.

The truth is that most advisors don't have the desire or the time to crunch numbers, do endless hours of research, or become analysts or due diligence specialists. But they do need to understand how to interpret the data they receive from the various sources they use. One of the challenges with most platforms, though, is that few offer tools to aid in the interpretation of the information they provide or help advisors gather. "Analysis, interpretation, application use, how the managers fit with other managers, what kind of clients should use them, what kinds of accounts they should be used in-most don't do any of that," says Mendelson. "These platforms allow advisors to search databases and then require them to spend a great deal of time analyzing the data to determine the fit with their clients and their portfolios. I believe most advisors do not want to be analysts," he continues. "They'd rather have a conversation and have all the data they need so they can know what's going on. Only then will they have time to manage relationships and attract assets."

As a result of this desire to have qualified analysts do the interpretation for them in addition to having all the tools they need at their fingertips, the newer platforms are incorporating deeper levels of due diligence, research and customization for independent advisory clients. Most of these new offerings are from business consultants. They not only assists independent advisors in setting up investment advisory businesses, but also provide focused technology support for risk-return analysis, proposal generation, basic due diligence and a mix of investment options including ETFs, mutual funds, SMAs and variable annuities.

"You're seeing a trend toward firms adding levels of due diligence, which really are important at all levels to the client, the advisor and the firm or sponsor that's creating the platform," adds Westphalen. "Different types of platforms may have different types of relationships."

For example, Denver-based Prima Capital has analysts on staff (as does Capital Market Consultants) who visit managers on site. It then provides the analysts' research to its advisory clients. Prima is also teaming up with decision-making software innovator Klein Decisions to offer advisors added resources for determining the proper asset allocation and manager mix. Klein, which is based in Raleigh, N.C., offers a K4 product that aids in the selection of separate accounts as well as in strategic decision-making. Prima provides due diligence, research and advisory services on more than 500 separate account products from 250 money managers. Other entrants into this field are lining up with new offerings soon (see sidebar for more services).

Adding Value For Clients

According to both Mendelson and Westphalen, advisors need to embrace programs that provide the deeper levels of due diligence and clearly articulate the difference between what the due diligence service provides and what the advisor provides. "It's not to diminish the advisor's role in the equation, it's just a much more powerful conversation for me to have with a client by saying, 'Based on what we've discussed and on the financial plan we've created, we now have to implement an investment strategy we designed based on the amount of time, volatility and return you desire. Here's the asset allocation model we've provided you and the managers that Wilshire [for example] has determined would make sense for you and your portfolio. Here's what it looks like.'"

He further states that the bottom-line responsibility of advisors is not necessarily to do the due diligence themselves but to find the best capability for doing it, and that might include an outside source. Potter notes that advisor attitudes also have to change. "They have to put on the consulting hat, which makes all the difference in the world for clients."

Veteran financial advisor Lewis Walker, CIMC, president of Walker Capital Management in Norcross, Ga., and recent recipient of the Money Management Institute's 2004 Pioneer Award, adds an important footnote to the subject of doing personal due diligence combined with using outside sources. "As most everyone agrees, research and due diligence on money managers, as well as ongoing monitoring, is a complex and time consuming process. As a financial planner and an investment management consultant, I believe asset management is a subfunction of a larger, holistic planning process. TAMPs (turnkey asset management programs) provide useful functions in organizing data for comparisons of one manager against another using a uniform yardstick. Data is also in useful form for presentation to a client. Nevertheless, when a decision is made to consider a manager, I contact them, get to know their people, secure their data and whenever possible conduct personal due diligence on site. This is a more holistic method, in my opinion."

An integral part of an advisor's job is evaluating investment manager performance throughout the hiring, reviewing and terminating processes. Ongoing monitoring and careful oversight of the manager, to ensure the IPS is being followed and that there is no style drift, are vital measures that need to be taken as well. For their benefit and that of their clients, every advisor should also conduct ongoing performance evaluation. There are obvious limits to what an advisor can analyze, including returns-based and holdings-based analyses, without more sophisticated tools in hand or the help of a third-party source. Termination of a manager is also a result of intense due diligence, and a process is used to make the decision and follow through with that decision. Says Mendelson, "Manager evaluations are neither all quantitative nor all qualitative, but an ideal combination of both helps convey the story of how well a manager has done, how they did it and how likely they are to do it in the future."

In Conclusion

If the process of selecting, monitoring and evaluating investment managers was like constructing a house, it would be built with the bricks and mortar of science but would rest firmly on a foundation of professional judgment, Mendelson tells advisors. The strength and quality of the decisions in engaging or retaining a money manager are dramatically enhanced by employing a sensible and repeatable review process-no different than following an architecturally sound process when building a house and maintaining the structure once completed. "Employing and retaining investment managers, like any investment discipline targeted for success, requires great initial care and ongoing decision-making."

A good blend of technical expertise and tools, as well as good old-fashioned judgment and personal contact with managers, could prove to be the best approach for successful search and evaluation from the immense talent pool available to advisors today.