3. Fees for separate accounts have fallen, producing benefits and challenges. Total SMA fees used to be as high as 3%, but they have rapidly fallen to an average range of 1.8% to 2.0%. This has created much greater interest, but at the same time has placed significant revenue pressure on investment management firms. In an arena with significant hurdles before sustained profitability can be achieved, this downward pressure on fees is a primary concern expressed by many investment managers.
4. Margins will be reduced in the early years of an SMA initiative. Operating an SMA business as part of an overall investment-management firm initially will be a drag on firm margins. The traditional $100 million in asset profitability gauge, common in the fund world, simply does not apply here. SMA breakeven probably lies closer to $500 million, once the additional operation and distribution expenses are incorporated. The good news is that at $1 billion, an SMA business can achieve margins at or above the current levels seen in the investment-management industry as a whole.
5. Operational excellence is absolutely essential. We cannot stress enough the critical role that operations play in the successful execution of an SMA effort. Excellence in other areas simply cannot make up for meaningful deficiencies in operational capacity. Asset managers with top-notch performance should not deceive themselves into believing that sponsors will overlook their operational mediocrity just to have the honor of access to their outstanding performance. According to SMA investment managers of all sizes, the most significant challenge they face today is dealing with the operational realities of the business. More than two-thirds of the firms we surveyed listed operational issues as a top challenge. We cannot overstate the need for investment managers to have an operational platform that is flexible enough to cater to the unique needs of the various program sponsors. Because the demands of every SMA program are different, having an operations staff that is able to integrate multiple trading and accounting systems should be a primary goal of every investment manager.
6. Recruiting qualified professionals is a major challenge. After operations, the next most challenging aspect of the SMA business from an investment-manager's perspective is the task of finding, hiring, training and keeping qualified personnel. Distribution and operations personnel require unique skills that are not always immediately transferable for those with mutual fund or institutional experience. The industry also lacks the tools and data needed to plan for deploying sales teams and for staffing operations groups as businesses grow.
7. Investment managers should do their own due diligence on sponsor programs. SMA program sponsors have teams of individuals dedicated to evaluating (the investment) firm. Investment managers should develop a similar team of their own to carefully evaluate sponsor firms and programs to find the best fit for their organization before making the decision to join. The cost of participating in an ill-fitting program can be disastrous. Thorough homework is a must.
8. The SMA marketing process is very different from that for mutual funds. It is imperative to keep in mind at all times that it is a process, not a product. Intermediaries believe that if separately managed accounts are sold just like any other investment product, the client will typically only invest the minimum per account. However, if the intermediary does a good job of first establishing the need for the process in the client's overall portfolio and then presents a separately managed account program as the solution, the rep can gather a much greater share of the client's investable assets.
9. Maintaining dual books is expensive, but wise. The decision whether to maintain accurate duplicates of the records kept by the program sponsor will have significant implications on SMA business and possibly the entire investment-management operation. It profoundly affects the ability to create AIMR-compliant performance reports, track SEC compliance issues and accurately monitor sales and assets.
While the prospect of going through this extra effort may seem expensive, redundant and even unnecessary, we believe the benefits far outweigh the full costs of not keeping accurate books in-house.
10. Core investment disciplines dominate, but there is room for everyone. Large established investment managers will continue to dominate core SMA product offerings and will try to expand their reach by introducing additional varieties of core-management disciplines. However, small and midsize investment firms still have a great opportunity to make their initial splash in complementary investment disciplines. After gaining a following and establishing some momentum in less penetrated investment categories, they can then attempt to branch out into the more core disciplines, where can have a better chance of competing for business against their well-known and entrenched competitors.
Kevin Keefe, CFA, is vice president and senior consultant at Boston-based Financial Research Corp., a provider of competitive market research and analytic services to the financial services industry. For more information on this and other studies, contact him at (617) 557-3412.