Between a rock and hard place: managing client interests versus client expectations when it comes to sleeve-level accounting, rebalancing and reporting.
Last week, we presented Part I of our guide to sleeves. We made two main points:
- In an overlay program, sleeve-level accounting, rebalancing and reporting are expensive and interfere with optimal tax and risk management.
- Some clients expect sleeve-level performance reports.
This sets up a conflict between doing what’s right for the client and doing what the client wants. It’s easy enough to say “do the right thing!” but that isn’t helpful, to the advisor or the client, if the client simply walks away.
What then, is a firm to do? We believe there are four strategies to balance serving client interests and meeting their expectations:
Strategy 1: Sleeve-based as an exception
Solution one is to make holistic management your default approach and deal with clients who ask for sleeve-level reporting on a one-off basis. Most clients don’t ask, so there is no problem to solve. If a client does ask, begin by explaining the drawbacks. If the client still insists on sleeve-level reporting, open “true sleeves” — that is, actual separate accounts, with unique account numbers — for each sleeve. This is operationally more costly, and, typically, this accommodation is made only for large, usually institutional accounts.
Strategy 2: Alternate reporting
Solution two is to provide clients with more meaningful and less expensive substitutes for sleeve-level reports. Specifically, firms share with clients the details of the firm’s due diligence and selection methodology for selecting and deselecting model vendors, whether conducted in house or subcontracted to a consultant. Typically the factors considered include the model vendor's own composite returns (the returns of the portfolios the model vendor controls directly, each of which is usually managed as a single sleeve), an analysis of style consistency, management background, etc.
Less commonly, we see some firms create special-purpose funded reference accounts — one reference account per model — that are managed without constraints exactly to their models. They report the returns of these reference accounts, which accurately show the value of the model in the context of the overlay managers trading environment.
Strategy 3: Eliminating “product” performance
Solution three is to eliminate “product” (i.e. security and sleeve) performance entirely. Instead focus on portfolio-level returns. This change in focus is usually part of a larger embrace of a goals-based framework. Even portfolio-level returns are shown not to judge performance relative to benchmarks but instead to establish whether the investor is on track to meet their goals.
Strategy 4: Holistic management with sleeve-level reports
The fourth solution is to manage assets without sleeves, but provide sleeve-level reporting anyway. These firms recognize the shortcomings of presenting sleeve-level performance for a holistically managed account. As discussed in part 1, each sleeve’s performance will represent the combined contributions of the model vendor, the overlay manager, the other model vendors and the actions of the overlay manager in other sleeves. As such, they’re not really useful, but firms present them because clients ask for them.
These non-sleeve strategies are not mutually exclusive, and we see most firms adopting some combination of all four.
The Future of Sleeves
We’ve argued that a holistic approach is less complex, less expensive and better for investors, but may run counter to client expectations, shaped by past practices. In the long run, the holistic approach will dominate. The advantages are too great and the countervailing pressure of client expectations will recede as memories of past practices fade.
We’re already seeing increased adoption of the holistic approach, with four specific drivers:
- General fee compression has put pressure on wealth management firms to reduce costs, and sleeves are expensive.
- As wealth managers de-emphasize “product,” they are de-emphasizing product-level performance reports, including sleeve-level reports. In their place, they are adopting a goals-based framework, as well as stressing risk and tax management, which are optimized in a holistic, non-sleeved, approach.
- The rise of low cost robo solutions has put pressure on firms to increase the level of customization provided. This lowers the value of sleeves, since customization and tax management compromise the integrity of sleeve-level reports.
- In response to the proposed DOL rule, firms are looking for ways to provide scalable, customized, compliant solutions that meet the fiduciary standard. This is only possible through increased automation. The complexity of sleeves makes sleeve-based approaches harder to automate.
We expect the adoption of this holistic approach to accelerate. If you’ve read this far, it probably means you have a stake in the questions at hand. We’d love to hear from you. If you have questions — or want to share your thoughts — please reach out to us.
For more on this topic, check out The Ultimate Guide to Sleeves Part 1.