Chapter 16: Separately-Managed Accounts
Separate accounts—also known as separately-managed accounts or “separates”—are segregated individual accounts with one or more investment managers. Unlike mutual funds, your investment is not co-mingled. Many investment managers participate in the separate account programs offered through major brokerage firms and other institutions.
It is expensive to access investment managers through a brokerage firm. A brokerage firm directs your money to one or more investment managers who manage a separate account for you. The investment manager charges an ongoing management fee, perhaps 0.75 percent. Then the brokerage firm charges what is known as a “wrap fee,” which is an ongoing fee that is wrapped around the investment manager’s fee (the folks who you are already paying to actually manage your money). The brokerage firm collects both fees each quarter, pays the investment manager, and keeps the rest.
One major problem with separately-managed accounts (SMAs) is the brokerage firm’s wrap fee, which can easily amount to twice as much as the investment manager’s fee. Unlike mutual funds, the ongoing fee for SMAs is not hidden. All you have to do is look at your statement to identify the total you are being charged—however, the total fee is typically not itemized—so it is difficult to identify what portion of the fee is paid to the manager, and what portion of the fee is paid to the brokerage firm.
One reason wrap fees are so high is that the brokerage firm may not compensate a financial advisor for selling SMAs, unless he negotiates a wrap fee above a certain level, such as 0.50 percent annually.
With SMAs, the financial advisor may receive a larger payout if he negotiates a higher fee. This compensation arrangement is clearly not aligned with your interests.
Keep in mind that this is just the wrap fee. When you include the investment manager’s fees and administrative fees, the net impact can be 3.0 percent in annual expenses.
If you learn nothing else from this book, you should learn how devastating investment expenses are. Three percent is outrageous, and so is 2.0 percent. The illustration on the next page depicts the wealth one would have accumulated from 1975-2010, given a $100,000 investment in U.S. large cap stocks, applying various annual operating expense ratios. This is the same illustration that appears in Chapter 6. It is equally applicable where SMAs are concerned.
SMAs provide an opportunity to control capital gains distributions and manage tax obligations. Mutual fund distributions can’t easily be managed in the most tax-efficient way. A more sensible way to manage both the tax liability and operating expenses is to simply purchase an index fund or ETF. Remember, the vast majority of investment managers fail to beat the indexes.
The next chapter provides a brief discussion of alternative investments.
Have a question? Contact Ed Mahaffy.
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