Fee-Based Advisors Clamoring for Muni Bond Ladders

Are fee-based advisors looking to move more managed account assets into municipal bonds?  There is evidence that this is the case and that muni bonds as a percentage of managed account assets could grow over the next few years.

Research from MMI/Dover shows consistent growth of fixed-income SMA objectives that corresponds to a consistent decline in domestic equity objectives. In mid-2010, domestic equity held a scant lead, 40% to 37%. Among model portfolios, taxable fixed income leads the list with 22.4% of assets, ahead of large-cap value (19.1%) and large-cap growth (17.8%).

Some of the broad investment trends that have surfaced in recent years–alternative investments and tactical asset allocation–can be found in managed accounts.  Jean Sullivan, from Dover Research, says that these programs generally have become more conservative, with an increase in fixed-income strategies.

While taxable fixed-income SMAs are the leaders, municipal fixed income doesn’t even make the top 10, holding less than 2% of portfolio assets. “Many investors in fixed-income SMAs are nontaxable, such as 401(k)s and pension plans,” says  “They hold taxable bonds, Treasuries, agencies, corporates and some asset-backed securities.”

Why would investors want to hold bonds via managed accounts instead of a bond mutual fund or a low-cost ETF that tracks a bond index? Financial Planning Magazine quotes Randy Dry, managing director of the institutional group at Thornburg Investment Management in Santa Fe, N.M.:

“For the same reasons that you’d use separate accounts for equities,” Dry responds. “Investors own the underlying securities, not shares in a fund. You can make trades that improve your tax position. And you avoid the ‘flow shock’ that may affect mutual funds.”

Dry explains that investors get bond ladders with his firm’s fixed-income SMAs. About one-tenth of the portfolio matures every year and the proceeds are reinvested in 10-year bonds. This strategy, which some other fixed-income SMAs also follow, can protect long-term bond investors against rising interest rates because money would be available for reinvestment at the higher rates.

Thornburg, which offers muni bond SMAs, has a $2 million minimum. With smaller amounts, investors may have less diversification and face wider spreads on trades, Dry says.

One of my previous blog postings, Current Challenges for UMA Sponsors, covered a session from the MMI 2011 Spring Convention. Representatives from both UBS and Merrill Lynch both reported that their advisors had requested the ability to provide muni bond ladders to their managed account clients.  However, there are issues that have blocked these offerings being made available, such as determining the proper minimum account size and the amount of alpha that muni managers can bring.

While UBS and Merrill are still considering bond ladders, other large sponsors have moved ahead to make them available on their managed account platforms.

For example, in March 2010, Schwab Managed Account Services™ partnered with PIMCO and launched a bond ladder offering called the PIMCO Municipal Bond Ladder Separately Managed Accounts—five professionally managed strategies that seek to generate income by leveraging investment opportunities in the municipal bond market.

According to Schwab:

PIMCO conducts continual credit surveillance, reinvests maturing securities, and provides institutional purchasing power, all for a highly competitive fee. The SMAs have an investment minimum of $250,000 and a program management fee of 0.35% for the first $1 million invested, 0.30% for the next $4 million and 0.25% for investments above $5 million.

PIMCO selects investment-grade municipal bonds with an average credit quality rating of A- or better at purchase. These are assembled in laddered portfolios with 1- to 6-year, 1- to 12-year, or 1- to 18-year maturity rungs.

Some of the benefits of adding a muni bond strategy to a managed account include:

  • Periodic income generation—The strategies seek to generate tax-efficient, periodic interest payments, which can be distributed as they accrue1 or reinvested into new bonds in the ladder. Of course, investing in bonds carries risks, including the risk that a bond may fail to pay interest or principal, and the risk that it may lose value.
  • Ongoing credit monitoring—The manager selects investment-grade municipal bonds and regularly monitors the credit quality of your account holdings.
  • Bond replacement—When a bond matures, the manager will reinvest the principal by purchasing a new bond, typically at the longest maturity range or “rung” of the ladder. The ladder is extended until you request a payout of principal or your account balance falls below the $250,000 minimum.
  • Direct ownership and transparency—Unlike fixed income mutual funds, a municipal bond ladder offers direct ownership of the underlying bonds.

LPL Financial also claims that their proprietary fixed income trading platform that allows financial advisors to build bond ladders, select products, and process trades online for municipal bonds, corporate bonds, new issue corporate notes, and FDIC-insured CDs.

An article from AdvisorOne.com, Trends in Separately Managed Accounts: UMAs, ETFs and Alternatives, confirms that Envestnet is also seeing an uptick in requests for bond ladders.  The article quotes Mike Henkel, managing director of Envestnet/PMC and Tom Simutis, an Envestnet/PMC senior VP in charge of relations with SMA managers:

Fixed income alternatives are of particular interest to advisors now—“no one wants to be on the long side of fixed income,” says Henkel. Simutis confirms that Envestnet/PMC is always getting requests for strategies that are “noncorrelated” to the broader stock indexes, but also “replacements for fixed income. SMA managers are using ETFs, they can use synthetic shorts, can buy bundles of equities.”  There’s a growing use of ETFs as a component of a SMA manager’s strategy, he says, “where the rest of the portfolio may be invested in stocks or bonds.”

What else are advisors looking for? Simutis says that on the fixed income side, in addition to alternatives “it almost seems like a move toward a more traditional approach; we’re getting a lot of calls” for bond ladders, because “they’re cheap and easily understood.”

While this evidence is far from conclusive, it does appear to be a trend that should be monitored.  It would advisable for sponsors to investigate offering muni bond strategies on their platforms, so that they will be ready to respond when their advisors start demanding it.

Current Challenges for UMA Sponsors

This post is a summary of a session from the MMI’s 2011 Annual Convention.

The moderator for this session was Lee Chertavian, Chairman & CEO, Placemark Investments. The panelists were Marilee Ferone, Executive Director, UBS Financial Services, Roger Paradiso, President, Chief Investment Officer, Morgan Stanley Smith Barney and Russell W. Tipper, Director, Third Party Discretionary Programs, Managed Solutions Group Merrill Lynch.

According to Dover Research, UMA asset growth was over 100% last year, yet at $123 billion, it makes up only 6% of
total managed account assets. 88% of sponsors report that UMA will receive the greatest amount of funding next year.

There was a lot of debate in the industry regarding overlay management program types between active, hybrid and passive, Lee commented. Back in 2007, sponsors were evenly distributed between the three, but by 2010, the vast majority (80%) had shifted to active overlay, using model portfolios.

There’s been a tremendous change in manager’s attitudes regarding model-based delivery. Among the top 25 model
managers, over 40% weren’t providing models just five years ago.

82% of respondents said that UMH was important, although the technology is still in its infancy.

UBS Strategic Wealth Portfolios

The UBS program is passive-only, with no models and no active overlay, Marilee informed us. It’s nondiscretionary,
except for the sleeve that the money manager controls. It has $6 billion in AUM, with an average account size of $1.3 million.

UBS provides a lot of flexibility for advisors to select investments from an open architecture with over 200 SMA managers to choose from along with 3,100 mutual funds and 300 ETFs. Hedge funds were available when the program started a few years ago, but demand died off due to their limited liquidity. Asset growth in 2010 was nearly 60%, Marilee reported.

Merrill Lynch

Merrill Lynch launched their UMA in 2007, Russ noted. It now has $22 billion in AUM and 42,000 accounts (average account size = $523,000) and is entirely model-based. They allow managers to retain discretion depending on the market that they’re trading in. Merrill sees UMA as a platform for delivering advice and leveraging their investment partners.

They offer a full spectrum and provide flexibility for advisors where they can implement a stand-alone SMA or a model containing mutual funds, equities and ETFs. Merrill’s core offering is focused on SMA, ETFs and funds with 40% of the business in stand-alone SMA and the other 60% in models. In most cases, they leverage the firm models and don’t allow swapping of strategies. Russ stressed that they want their platform to provide advisors choice and flexibility.

Morgan Stanley Smith Barney

We look at UMA as a solution-based platform, Roger stated. It’s open architecture and designed around the way the advisor and client want to engage. The platform offers over 250 SMA products using model-based delivery, over 300 40 Act vehicles, and over 150 ETFs.

Advisors can create custom asset allocation structures and their own models, which they can use as completion strategies. There are also asset allocations driven by the Global Investment Committee, which created eight models for advisors to choose from. In addition, they can select either strategic or tactical allocations.

Roger listed three client engagement models that are available:

  • Client Discretion (traditional)
  • FA Discretion
  • Consulting Group (CG) Discretion

The CG Discretion uses MSSB asset allocation models and handles manager selection ($25K minimums for all mutual
fund/ETF version and $500K for hybrid version where the firm creates a custom investment selection).  The personal level of the program allows advisors to select from options including tax-managed strategies, restrictions, and transitions.

The one constant, no matter what the engagement model, is the Private Portfolio Group acts as the overlay portfolio manager. A key aspect is the proprietary technology that they’ve built over the past 15 years. There are over 250
people on the team with an average experience of 12 years.

What fixed income options do your programs offer? Do you support muni bond laddering?

The UBS program does not support direct purchase of bonds. They provide the ability for FAs to choose a fixed income allocation that is fulfilled using ETFs or mutual funds. FAs have asked for muni bond laddering, Marilee said, but they haven’t built it out yet.

Merrill advisors have access to top industry fixed income talent, according to Russ. On the taxable side, their overlay manager does the full implementation and in the municipal space, they give managers discretion. Their FA’s have asked for muni bond ladders, but there are issues such as determining the proper minimum account size and the amount of alpha that muni managers can bring.

MSSB offers a dual-discretion model, where they oversee everything, but the fixed income managers do their own trading.

What changes did your firm make to your front-end to add financial planning to your UMA platform?

Merrill has a front-end financial planning engine that’s fully integrated into their advisor desktops, Russ pointed out. However, it doesn’t have the ability to go from idea to execution. In other words, it doesn’t connect to the portfolio
construction or UMA implementation process. Their next generation UMA platform will integrate financial planning
into so it will be an end-to-end process.

Roger confirmed that MSSB is in the same boat. They need to make the connection between the financial plan and
implementation. They should follow through with the plan over the client’s lifetime, but it’s extremely challenging.

How have you changed performance reporting to better support UMA?

UBS provides all standard performance reports, including monthly and quarterly that go down to the sleeve level including attribution analysis. Merrill leverages a single platform across their entire business, so clients receive a similar report whether they’re in an FA-directed, client-directed or discretionary account. They’ve made enhancements to the platform to show sleeve level performance and attribution and historical changes over time.