Investors Turn To SMAs For Transparency, Control

Jan 20 2009 | 3:09pm ET

By Michael Murray -- The global hedge fund industry lost $64 billion in assets in the month of November, with $46 billion of that coming from investor redemptions, according to Bloomberg News. With so many hedge funds gating their funds to protect ongoing investors, it raises the question of just how much larger that investor redemption number would have been if all investors who wanted withdrawals could have accessed their investments. 
 
The billions taken out in redemptions will eventually be reinvested. It is the responsibility of those in the financial and investment community to provide opportunities that are in-line with what investors are seeking. For much of the last two decades, hedge funds have been an important investment tool for wealthy Americans and that will continue. But as investor redemptions illustrate, a percentage of investors are seeking alternative vehicles.
 
Control & Transparency
 
For some investors, the lack of access to their assets, the inability to exert control over their investment strategy, and the lack of transparency is a hurdle they will no longer be able to overcome. Throughout much of 2008, investors had been clamoring to withdraw cash from their investments. It was this mass movement toward liquidity, pulling cash out of investments, which ultimately exposed Madoff and ended his long running Ponzi scheme. To investors weary of investments that provide them with limited control and transparency, the Madoff scandal was proof that control and transparency are as important as their rate of return.
 
Asset managers need to provide this group with alternative investment strategies. Money still needs to be managed, but the vehicle that is used to manage financial assets will likely change and separately managed accounts and ultimately, unified managed accounts, will grow in popularity. They both provide the market expertise of an asset manager with the kind of individual control and transparency that many investors will now be demanding.
 
The Rise of Separately Managed Accounts
 
The benefits of SMAs are well known to many asset managers: the lack of embedded capital gains; the ability to manage capital gains through tax gain/loss harvesting; and the ability to purchase more or less of an individual security to balance out an existing investment portfolio.

An added benefit of SMAs is the amount of transparency that is a necessary and integral part of this investment vehicle. An SMA has multiple, individual parties involved in the investment process, which makes it less likely for fraudulent activities to take place. There is the asset manager who works with the investor to create and execute a strategy that meets that individual’s goal. There is also a prime broker dealer who is responsible for the day-to-day maintenance of the account. Finally, there is the custodial firm, which handles the clearing and custody of the investments. In some cases, there may even be multiple custodians.

Having multiple, independent parties handling the different steps involved in executing an investment plan make it exponentially more difficult to perpetrate a fraud.
 
From SMAs To UMAs
 
As the number of investors seeking separate accounts continues to grow, the next logical step in the progression of the separate account is the unified managed account. Unlike an SMA in which each asset class has its own account (and set of paperwork), the UMA is a single account with one registration that can encompass virtually every investment vehicle in a portfolio. The ability to manage stocks, bonds, ETFS, mutual funds, etc… all in one account makes the administration of the account easier for both the asset manager and the investor.

According to a study by Dover Financial Research, investment managers and sponsors expect that between 30% and 50% of SMA assets, now valued at $519 billion, will convert to the UMA model portfolio within the next five years.
 
A report released this month by the financial research and consulting firm Celent is equally enthusiastic about the UMA market. They estimate that by 2013, the UMA market will reach roughly $327 billion, from $73 billion at the end of 2008, growing at an annual compounded rate of 35%.
 
However, a major factor in just how fast this segment grows will be the speed at which the financial industry will embrace the standardization and automation necessary. Technology has made it possible for investment advisors to offer alternative investment vehicles to a broader marketplace, but combining multiple investments and coordinating trades across all of them requires a commitment to advanced reporting and performance reports. Ultimately, as investors continue to demand this model, the industry will have to work with custodians to establish the necessary data feeds for reporting.
 
While tax benefits and rate of return will always be an important part of an investment strategy, investors will be seeking vehicles that emphasize control and transparency. A result of this shift in paradigm is that wealth managers will have to provide investors with vehicles that meet their current demands. For 2009 and the near future, SMAs and UMAs will meet these needs and gain in popularity.
 
Michael Murray is a Partner at Shoreline Trading Group in New York


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