by Carly Schulaka
You've heard of overlay management, but do you really understand it and how it could possibly build efficiencies and help you better serve your clients?
Caroline Austin, chief investment officer at FSW Advisory Services, an affiliate of FirstSouthwest that provides overlay management services to advisers nationwide, spoke about overlay management at FPA's Business Solutions conference in March. FPA recently caught up with Austin to learn more about unified managed accounts and to get the skinny on the role you can play as an overlay manager.
FPA: What is overlay management?
Austin: Here's a common scenario: You meet with your client and promise that you will manage his portfolio exactly as he has instructed. But how do you really deliver on that promise? If you have more than several dozen accounts, you start to lose the ability to remember every nuance and detail, every preference and every stipulation. In the end, you either reduce what you would like to promise, you spend valuable hours-reducing your productivity and bottom line-or you have unhappy clients because you can't deliver what they expect.
Overlay management is powerful technology you can have right at your desktop that allows you to rebalance a client's portfolio, manage his tax bill to exactly his instructions and combine your own management expertise with institutional third-party asset managers. Trading is completely automated, and all trades are allocated and averaged priced to your client's account.
FPA: Couldn't advisers just use their CRM software to track how to manage each client's portfolio?
Austin: CRM technology helps you remember certain details, but it doesn't connect to your portfolio system. Overlay technology automates your client's investment policy statement. CRM technology does not automate your trading, rebalance among all portfolios-whether managed by you or others-screen for social criteria, help you reap gains or losses, or prevent small trades when rebalancing.
FPA: How are unified managed accounts and overlay management different from separately managed accounts?
Austin: SMA accounts bring professional management to the masses. Though efficient, once they are set up, changing asset allocations, changing managers and dealing with inflows and outflows can be time consuming and complex. If the average adviser with 400 accounts changes a manager, he or she goes through over 3,600 steps to do so. The complexity is nightmarish.
The UMA is the first account to be completely agnostic to internal or external managers, product selection, unique asset allocations, unique inflows and outflows, "do not buy," "do not hold" and many other custom requirements of investors. Overlay gives us the power to create a portfolio of portfolios for each client. Pieces of the portfolio, referred to as "sleeves" or "targets" are set for each client, and each target is managed according to its own policy. The overlay manager prevents any target manager from violating investment policies of individual clients. The target manager can be a mutual fund, collection of funds, institutional third-party managers or the overlay manager himself.
FPA: What's the biggest benefit of using overlay management?
Austin: Productivity for both client and adviser. A portfolio manager can now easily handle double the number of accounts he formerly managed by automating so many menial and cumbersome tasks. Operational efficiencies abound and productivity in your office soars. And when productivity soars, profit margins widen. Additionally, it costs less for your client. It's a win-win.
FPA: And the drawbacks?
Austin: Some people argue that you cannot measure the value of the overlay manager. And I admit that it is difficult. While you will still measure and watch the performance of each target manager, each client may add sufficient restrictions so as to produce very different results. But that result may be exactly what the client wants or needs. For example, if your client needs to harvest losses and sells securities more prematurely than the target manager may want to, a client may miss out on some price recovery. However, if that loss is used to offset a gain the client has elsewhere, it may be more economically advantageous for the client. Those decisions are difficult to measure in classic performance measurements.
FPA: What about cost?
Austin: The real power of overlay is substituting institutional class manager models for mutual funds, taking control of all tax lots, all trading, expenses and management fees. The average fee for an overlay account will be between 160 and 255 basis points, all in, if mutual funds are not used. While some may find that high, you can compare that with a typical mutual fund wrap account with a drag of between 320 and 575 basis points or even higher.
How do these fees get so high on mutual funds? Trading costs. These costs are rarely disclosed by the mutual funds, and are on top of the expense ratios, which are disclosed. Yet trading costs are typically capped in a unified managed account and are always fully transparent. All things being equal, that is real money that your client puts in his pocket, year after year.
The previous numbers include the cost of the technology-at least speaking for ourselves-and while your clients may think your fees are being increased, when presented with the facts, I think the sale is an easy one.
Two studies, both published in the Journal of Wealth Management, looked at after-tax returns and the effect of tax management on the portfolio using overlay management. Stein and McIntire1 found that after-tax returns improved as much as 200 basis points annually, on average, over a 10-year period just through better cost control and cost compression. As for taxes, Berkin and Ye2 found that the first year yielded as much as 700 basis points of excess returns, sharply declining in the first five years, but still producing as much as 50 basis points annually 25 years later.
FPA: Is overlay management the way of the future?
Austin: Our opinion is that overlay management will become the standard in the industry, merging internal and external management in a single account. Mass customization will be made simple, so that you may not just listen, but act on your clients' priorities. Advisers will become client-centric, not product-centric, and emphasis will be placed on finding the best ideas and matching them with client needs.
Carly Schulaka is managing editor of Practice Management Solutions. Contact her at Carly.Schulaka@FPAnet.org.
1. Stein, David and G. McIntire. 2003. "Overlay Portfolio Management in a Multi-Manager Account." Journal of Wealth Management (Spring): 57-71.
2. Arnott, Robert D., A.L. Berkin, and J. Ye. 2001. "Loss Harvesting: What's it worth to an investor?" Journal of Wealth Management (Spring): 10-18.