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.

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