Rep as PM: The Inside Scoop – Part 1

This post is a summary of a session from the MMI 2011 Fall Solutions Conference that was held in NYC last month.  It is part 1 of a 2 part series.  You can read part 2 by clicking here.

Marc Zeitoun, Managing Director, Head of Distribution, Rydex/SGI

Jay Link,
 Managing Director, Managed Solutions Group, Merrill Lynch
Peter Malafronte, 
Executive Director, Managed Accounts, UBS
George Raffa, National Sales Manager, Asset Management Division, SVP, Raymond James

I felt that this was one of the most useful sessions at MMI this year because the panelists all shared lots of information about their firm’s advisory business, including statistics (my favorite) and details about the inner workings of their programs.   Also, the moderator did an excellent job moving things along and asked insightful follow-up questions, which gave the panelists a chance to elaborate on some key concepts and helped make the session more interesting. — Craig

Rep as PM (RPM) and Rep as Advisor (RAA) are the fastest growing fee-based programs in the industry, increasing assets 40% annually over the past three years.  Any asset management firm that doesn’t have a strategy to address RPM is missing the boat.

Which term is more accurate, Rep as PM or Rep as Advisor?

Jay believes that the term Rep as Advisor makes more sense since advisors do quite a bit more than just portfolio management.  They act in some ways as both investment consultants and wealth managers.  This is an entrepreneurial community and some RPM advisors consider themselves to be style-specific and market themselves as money managers.  Other advisors see RPM as just another level of service that provides a better overall client experience.  They use discretion as a tool to deliver more holistic advice.

Peter really doesn’t like the RPM title, since advisors are acting in an investment advisory capacity. Rep as PM doesn’t adequately capture what the advisor is doing for the client. Planning, liability side of the balance sheet, trusted council. RAA is more accurate.

George feels that RPM works best for teams that are headed by a financial planner with one person that oversees the portfolios and spends 100% of their time on it.

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The Vanishing Tailwind of Economic Growth

The tailwind of economic growth that drove our economy to new heights for the past thirty years has disappeared, according to Curtis Arledge during his session at the MMI 2011 Fall Solutions Conference.  The source of the tailwind was the extraordinary amount of debt taken on by the government, corporations and individuals, which reached levels not seen since the Great Depression, he emphasized.

Curtis, who is Vice Chairman and Chief Executive Officer, Investment Management at BNY Mellon, explained that the ratio of our total debt to GDP is at a higher level now than it was in 1929.  At that time, the debt to GDP ratio reached a peak of 2.3x (in other words, $2.30 of debt for every $1.00 of GDP).  After the market crashed, he added, it took almost 50 years for the economy to deleverage down to 1.5x.

Starting in the late 1970‘s the ratio started growing again until it reached another peak of over 3.5x in advance of the recent financial crisis in 2008. More than three years later, we’ve only managed to reduce the debt-to-GDP ratio to 3.3x, Curtis observed. At this rate it’s going to take a long time to get back to a safer level.

Every time we had a problem in our economy, from the 1980’s until 2007, the solution was to create some new form of leverage. This acted like a tailwind to our economic growth.  The events of 2008 demonstrated that new leverage solutions aren’t the answer anymore, Curtis emphasized.

The rest of the developed world has similar debt problems and they’re also trying to reduce their debt-to-GDP ratios. This global deleveraging will dampen future growth, Curtis noted.  Risk-based capital faired especially poorly in Britain, where banking assets went from 1x in the early 1800’s to 6x the size of the entire UK economy by 2007.

Curtis noted that the process of reducing our debt load won’t be as bad for us as it was for Japan after the 80’s boom, since our economy is more multinational. Our economy benefits from being able to move assets around the globe as needed. This will shorten the deleveraging cycle, he predicted.

The Growth of ETFs

80% of global assets under management is in concentrated in the US and Western Europe. Most assets in the rest of the world are held on bank balance sheets because banks were the only providers of capital. ETFs are helping to change that by opening up overseas markets and bringing in more outside investment. The result has been tremendous growth of the passive investments industry. Curtis pointed out that the price of access to Beta is falling fast.

The use of ETFs has been growing in managed accounts, as I wrote about in a prior blog posting, Managed Accounts: Future Trends, Projections and Opportunities.

While the assets invested in ETFs globally has surpassed $1 trillion, they have begun to attract attention from regulators, especially after a suspected rogue trader managed to lose $2.3 billion at UBS and tried to cover his tracks using fictitious ETF trades.  ETFs have also facilitated insider trading, as explained in this blog post from the Reuters Financial Regulatory Forum:

Also of concern for regulators is “ETF stripping,” wherein a trader with non-public information purchases (or sells short) an ETF representing an index of securities, and then shorts (or buys) all of its constituents except the one about which he or she has non-public information, amounting to a disguised position in a single security.

Advisor and investor technology platforms are improving at exponential rates. Generation Y and Millenials won’t invest the same way as previous generations did, Curtis said. Technology is not only democratizing access to the world’s best investment managers but also allowing investors to easily see the alpha-beta separation in the marketplace. Firms that delver sub-par performance won’t be able to survive for very long. They also won’t be able to distract investors from their failings with flashy advertising campaigns.

For the past 30 years, the investment management industry has spent their marginal dollars on asset gathering. To be successful in the new paradigm, these marginal dollars should instead be spent on improving investing, Curtis warned. Security analysis and basic research should take priority over marketing, if firms want to be successful.

Back to the Future

Clients are looking to their investment managers for solutions that shield them from volatility in the markets and avoid taking losses in the case of another bear market, Curtis continued.  Absolute return products of today are the balanced funds of the past. No one was interested in balanced funds while the tailwind of leverage was driving markets to new heights. In the current environment, where uncertain is the only consistent thing, investors want product that dampen volatility while delivering steady returns., he advised

Model Delivery is Risky Business, According to Manager Survey

Most investment managers believe that the risks associated with communicating model changes to sponsors are significant and have the potential to result in negative impact to their firms. This was one of the results of a survey done by Dover Research as reported by Jean Sullivan at the Financial Research Association’s 9th Annual Managed Account Summit, which took place in Boston last month.

Jean reported that model managers support an average of 6.5 model platforms each, with some managers supporting as many as 20 different sponsor platforms!

47% of managers surveyed say that they support fewer than 5 platforms, 37% support between 5- and 10 platforms and 17% support more than 10. These additional linkages can lead to elevated risk, Jean warned.

Jean told us that every investment manager that Dover spoke to is concerned that sponsors won’t be able to implement their trade instructions accurately. This is complicated by the numerous proprietary communication infrastructures developed by sponsors with many variations existing on multiple dimensions such as different delivery mechanisms (email, fax, web portals) and different messaging formats.

Sponsor Trading Constraints Are a Concern

A big area of concern for managers is trading constraints, Jean noted, due to the following issues at sponsor firms:

  • limitations in data formats
  • sponsor weight and volume restrictions
  • basis point limits
  • inability to implement price limits
  • inability to put securities on hold for more than 30 days
  • constraints on the number of trades
  • inability to implement international strategies

Three Types of Model Risk

Investment managers in the Dover survey identified three different types of potential risks that arise from model delivery:

  1. Reputational – defined as performance dispersion due to the inability of the sponsor to implement the manager’s model. This could be caused by a manager wanting to make an intra-day model change, but can’t because the sponsor doesn’t support it.
  2. Best Execution – defined as the inability of the sponsor to achieve best execution due to trading restraints. Trade rotation processes influence best execution, because there is no automated feedback regarding trade execution, so the manager doesn’t know when their trades have been executed. It could be due to sponsor firms competing against each other in the market. It could also be due to delays in communicating model changes.
  3. Operational – defined as the increased risk of errors due to the manual nature and inconsistency of the current model update processes. For example, if the manager’s operations staff makes an error in a model change, the manager is then responsible for making sponsors and their clients whole, even if the mistake isn’t discovered until months later. This is an area of significant cost and concern for investment managers.

The managers were then asked to rate which of these risks are “significant”. 50% selected operational, 45% said best execution and 17% chose reputational.

Due to the many issues arising from model communication, many managers are starting to build out their own model validation processes to reduce manual error and monitor best execution at the sponsor, according to Jean. Also, 67% of managers believe that a centralized model service that provides a standardized method to implement and monitor trade rotation would reduce risk.

The Model Management Exchange (MME) from DTCC is such a centralized model service, Jean said. It is secure and redundant communication system with integrated audit trails incorporating validation and confirmation features. It can also facilitate the trade rotation process, but this would require sponsors to send their execution data to DTCC.

The industry should take the opportunity to do something now to address the risks surrounding model delivery, urged Jean. I agree that something should be done, but what exactly?

Before anything can be done, both sponsors and managers should agree that they must work together to solve the problems. The risks expressed by managers are due to a complex mix of factors and cannot be easily mitigated and especially not in isolation.

A centralized model hub, such as the DTCC’s Model Management Exchange (MME) or Fiserv’s Model Information Exchange (MIX), which is planned for 2012 release, could help, but only if they achieve critical mass and then they can only help on the communications side. Risks that are due to specific sponsor’s model policies (i.e. Inability to implement price limits, trading windows) or manager operational issues (manual errors) will still exist no matter how the model information is delivered.

Are Managed Accounts Obsolete?

This post is a summary from a session at the Financial Research Associates 9th Annual Managed Accounts Summit in Boston, MA.

These are three of the most frequently asked questions regarding the managed solutions industry according to David Gardner, Principal, Smart Consulting Firm, LLC.

Are managed accounts obsolete?

David informed us that managed solutions today are far from dead and are, in fact, alive and well. But we shouldn’t lump all advisory solutions together, he warned. As reported by Dover Research in the most recent edition of MMI Central (see the table below), Managed solutions reached $2.3 trillion in total AUM as of 2Q 2011. This was a 3.1% increase from 1Q 2011 and a 31.8% increase from 4Q 2010.

Clients are no longer seeking products, but solutions, David advised. They want greater rationalization, efficiencies of holding disparate assets, styles and strategies on a single platform.

Will the UMA kill off the SMA?

SMAs are far from dead, David continued. Third party, actively managed investment strategies provided by professional managers in fee-based accounts are still a viable part of our industry, he insisted.

Third party managed accounts for both sponsors and investment managers had trouble achieving operational scale when they maintained duplicate infrastructures that lacked standardization, according to David. The advent of UMA model portfolio programs provided efficiencies in areas such as investor profiles, account maintenance, custody, and trade execution, which helped firms deal with operating margins that have been declining over the past two decades, he said.

As of 2Q 2011, the SMA market showed a respectable growth rate, relative to the broader equity markets, growing by 2%, with $6 billion in net new flows, which is a positive indicator given the current market environment, David acknowledged.

From 2008 AUM until 2Q 2011 assets have grown steadily in SMA Advisory. During this period, as reported by Dover Research, SMA assets grew from $476 billion to $596 billion, which is a 25% increase. The growth of SMA assets has been in a steady decline since their peak in 2003. UMA market segment grew the fastest (7.7%) of all segments in the last quarter. It was largely attributable to newly launched programs, David said. SMAs aren’t going away, he assured us, they just have found a new home. They’re relocating onto UMA platforms with a lot of new friends living in the sleeves next door such as ETF, mutual funds, fixed income, multi-currency and alternatives.

It’s not SMAs vs UMAs, David argued, since SMAs have always been an available component of a UMA.

Are UMA model portfolios just a way to marginalize manager intellectual capital and compress their fees?

David’s point of view is that managers shouldn’t look at model portfolios in a negative light, they should look at them as a way to unburden themselves from maintaining a duplicate client account infrastructure. Model portfolios, he added, allow managers to do what they do best, which is managing money.

David pointed out that this is an age-old efficiency question with SMAs. As a manager, would you rather compete for a piece of a slower growth pie of SMA Advisory, and accept ever declining margins, or focus on the UMA model portfolio market, which is growing exponentially, although with lower, yet very stable fees, but with less overhead cost?

DTCC projects that the number of models being distributed will grow from 1,100 today to over 13,000 by 2015, David reported.  They also project in the same timeframe that half of SMA assets will convert over to UMA platforms.  They’re seeing announcements every day as more sponsors commit to wholesale conversions of their existing SMA relationships into UMA model portfolios, David confirmed.

David summarized by saying that UMA model portfolios allow managers infinite scale and efficiency to deliver not only their intellectual capital but also new products with increased profit margins and increased operational efficiencies.