Separately Managed Accounts – Don’t Ask, Don’t Tell and The Importance of Due Diligence

In this article of my Separately Managed Accounts (SMA) series, I discuss some advanced topics that even some sophisticated investors may not think about. Because SMAs do not issue registered prospectuses, investors need to rely on other sources for investigating and evaluating the manager. In investor-speak, this is referred to as due diligence. Like doing your homework on a service provider, comprehensive due diligence should include detailed information in the following areas:

Performance Data: A manager should be prepared to share performance data (annual and preferably quarterly returns achieved) since the beginning of the strategy. The information is usually contained on a composite - a table showing aggregate performance for all fee-paying accounts in that strategy. A good question to ask here is whether the composite complies with the Global Investment Performance Standards (GIPS) set by the CFA Institute and whether a competent third-party auditor has provided a letter affirming compliance with the standards. You also want to see NET performance, that is the performance of after all fees and expenses have been pulled out.

Be sure to read the fine print – some firms report “blended performance” in which they combine performance from an older “institutional composite” (your advisor should understand what this means) with the SMA to make it appear that the managed account has a longer performance track record. This must be disclosed, but it’s often buried in the footnotes.

Many advisors find “selling performance” and easy sell. In reality, most of the time, investors who buy a product after an incredible performance run, wind up underperforming because they bought something that was too expensive. Remember, over the long-term, extremely few managers beat the market. Another way to think of it is: would you every buy a product at an all time high price?

Philosophy and Approach: Each manager has a unique investment philosophy and way of going about applying that philosophy to an investment approach. You will want to know whether the manager has a more active or passive style, a top-down or bottom-up approach, how he or she manages alpha and beta risk, the strategy's performance benchmark and other similar information. Here again, a good financial advisor should be able to explain – plainly and simply – what these things mean so that you can make an informed decision. If you don’t understand it thoroughly, do not invest.

The most important thing to look for is whether the manager has remained consistent to her approach. Some managers change their styles in changing market cycles in the hopes of outperforming. But if you’re buying a value manager, then you want to make sure that she remains so even in a growth environment.

Investment Process: Related to style, this includes a clear disclosure about who makes the decisions and how they get carried out. The roles and responsibilities of portfolio managers, analysts, support staff and others, who comprise the investment committee should be clear. Importantly look for the “sell discipline”. Without a sell discipline, the manager loses an important way of managing risk in the portfolio. Investor portfolios quickly become money losing if the manager doesn’t know when to sell.

Operations and Trading: The biggest issue here comes down to how fairly are you being treated as an individual client when it comes to trading. Some managers have extensive in-house trading platforms, while others outsource all non-core functions to third-party providers like Schwab or Fidelity. Some managers also have separate in-house trading platform that compete against each other. Ask about the Trading Rotation Policy if you want to learn whether you are getting stock allocations at fair prices. Regardless of the set-up, you want to watch out for any other clients of the firm that are getting preferential treatment over you. For example, a manager may trade all his institutional (read: big) clients before he gets to the retail side (individual investors like you).

Another useful area of information here is client and account services. Among other things, here you can find out about net client activity - how many new clients did the firm originate and how many left over a defined time period? What were the circumstances surrounding those who left? Were they service or account performance reasons?

Organization and Compensation: The organization and compensation of professionals is important in understanding whether their incentives are aligned with yours - especially the portfolio managers. Both are extremely important areas to cover. Understanding the calculations behind incentive compensation will provide a clue about whether the manager's incentives are aligned with yours as an investor. Often they’re not – as in the case where a portfolio manager’s compensation is the same regardless of how good his performance is.

Compliance History: Red flags in this area include prominent infractions with the SEC or other regulatory bodies, fines or penalties levied, lawsuits or other adverse legal situations. The SEC considers separate account managers to be investment advisors subject to the provisions of the The Investment Advisors Act of 1940. This means that the firm is regulated and audited by the Securities and Exchange Commission (SEC).

Much of this information can be obtained from the manager's Form ADV Parts 1 and 2 (with Part 2 having more of the details on strategy, approach, fees and biographical information on the principal team members). Performance data should be available directly from the manager, either online or through personal contact with a manager representative.

Before choosing to go with a Separately Managed Account, be sure that you have examined equivalent and cheaper ways of investing. If you find that a manager’s performance after fees is not better than his benchmark or index, then no amount of fancy marketing material or hard-core sales pitches should lead you to buying.

Remember, investing is a zero sum game and many people in the asset management industry are net negatives.