Wouldn’t it be great if ordinary investors could get the same type of investment management that really big institutional investors get? No, it wouldn’t.
Individual investors sometimes assume that big institutional investors are getting the best advice, and many wealth managers promote this belief, offering individual investors access to “institutional grade investment managers.” It sounds good, but it’s actually a bad idea. Individual investors are not just little institutional investors and should not be treated as if they were. Institutional programs are expensive to implement and badly suited for tax management. And that means they’re ill designed to meet the needs of taxable, individual investors.
Giving individual investors access to institutional grade investment products was the main idea behind Separately Managed Account (SMA) programs, in which an investor’s assets are divided among multiple specialist subadvisors. These programs are complex, which makes them expensive to maintain. And they only offer limited levels of tax management and customization. This is in the nature of the beast: SMA managers don’t like customization or tax management because it’s costly for them to implement and makes their composite returns noisy. And even if each SMA manager were on board, effective tax management and customization requires coordination between the subadvisors, which is impractical. Asset class rebalancing is especially tax-inefficient — it requires transferring assets from one manager to another, but no individual manager has an incentive to transition transferred assets tax efficiently.
When the first generation of models-based overlay programs came along, they were basically just a less expensive way to deliver SMAs. Instead of distributing control among multiple subadvisors, accounts were managed by one person, but divided into sleeves, each tracking a third-party manager's model. This approach is better for individual investors than traditional SMAs, but only a little. Each sleeve tries to faithfully replicate its model. That sounds good, but it simply ends up replicating the tax, customization and asset-class rebalancing deficiencies of SMAs. The account gets siloed into multiple parts, which makes effective tax, substitution and risk management difficult. And the structure is still expensive.
Second generation models-based overlay programs (like, among others, ours) step back from a product orientation and are therefore free to dispense with sleeves. Their focus is on helping the advisor manage portfolios holistically, putting customization, control of asset allocation and tax management front and center. Getting the intellectual capital of third-party managers is fine, but that should be only part of the story. Third-party asset managers (model vendors) should properly play only a supporting role. The advisor is the only person who sees the whole picture and therefore the only person who can effectively manage risk and tax. And the only person in a position to design a customized investment solution for each of their clients.
We think the decline of product-oriented value propositions is a good thing. Product-oriented approaches basically reduce advice to a sales function. This undervalues the advisor. It’s also becoming non-competitive. “Robo” and other highly automated solutions can provide product at lower cost. But advisors are in a unique position to understand each investor’s needs, tailor a solution and offer personalized guidance. In other words, advisors are in a unique position to treat investors as individuals, not little institutions.
For more on this topic, check out The Ultimate Guide to Sleeves Part 1.