Cumberland has utilized separately managed accounts to execute its fixed-income strategy since its inception in 1973, long before separately managed accounts (SMAs) were popularized in the early 2000s.
What exactly is an SMA? Per Investopedia: “A[n] SMA is a portfolio of assets under the management of a professional investment firm. In the United States, the vast majority of such firms are called registered investment advisors, and operate under the regulatory auspices of the Investment Advisors Act of 1940 and the purview of the US Securities and Exchange Commission (SEC). One or more portfolio managers are responsible for day-to-day investment decisions, supported by a team of analysts, operations and administrative staff. SMAs differ from pooled vehicles like mutual funds in that each portfolio is unique to a single account (hence the name). In other words, if you set up a separate account with Money Manager X, then Manager X has the discretion to make decisions for this account that may be different from decisions made for other accounts.”
The reasons for managing money in this fashion are the same today as they were then:
- Transparency (you know what you own)
- Flexibility to make strategic changes
- Ability to manage transaction costs and best execution
- Active management
- Individually catered management of clients’ objectives, including tax management, income production, state-specific needs, cash flow-specific needs, and ability to institute investment restrictions
Many of the elements of this update are the same as last year’s because the benefits of SMAs remain; however, the markets, technology, and regulation are always changing, which can affect supply, cost of execution, and relationships to other markets. New areas discussed here are municipal CEFs and ETFs, growing algorithmic trading by specialty investors and dealers, and new regulations designed to increase transparency, requiring brokers to show markups and/or commissions in certain situations.
At Cumberland we have a top-down approach to investment management. We look at global macroeconomic conditions and policies to assess interest rates and growth prospects and position our portfolios accordingly. Each market and/or sector is evaluated as to how it fits in the global outlook as well as how its idiosyncratic elements may affect supply and credit quality. The majority of our fixed-income portfolios are managed on a total-return basis using a barbell strategy to more quickly take advantage of changes in interest-rate and technical changes. In a total-return account, the return is measured against a benchmark, which is usually an index that is widely recognized. Outperformance may mean that individual portfolio returns are less negative than the benchmark’s in addition to positive returns that are greater than the benchmark.
Fixed-income total-return investing takes into consideration price appreciation or depreciation and the effects of coupon income generated and reinvested. Coupon payments over time are a large contributor to the return of an account, but the timing of buying and selling and where along the curve to buy or sell can greatly impact returns. Other buy-sell considerations include duration, or the sensitivity of a bond to changes in interest rates; embedded options such as call features; technical features like supply and demand, and credit-quality trends. All of these can affect the performance of a portfolio relative to an index or benchmark. Finally, to quote Cumberland’s John Mousseau, ”Active management means active thinking, not always active trading.”
We have been in a 37-year rally in the bond market, but if you don’t pay attention to points of entry and the other details, you can miss out on performance. Similarly, in an increasing-interest-rate environment, points of entry and exit can affect performance. The use of a barbell strategy allows us to invest in various short-term instruments that are liquid and to use them as ammunition to buy longer-dated bonds when interest rates rise or to take advantage of the higher coupon of longer-maturity bonds compared with shorter-dated bonds. Floating-rate notes and inflation-protected securities are investments that can help returns in the face of inflation and rising interest rates. We are prepared for various scenarios; however, unemployment and inflation remain low, and growth remains steady. In a recent piece, http://www.cumber.com/its-in-the-stars/, Bob Eisenbeis opines that the FOMC would continue with gradual tightening, since policy is still accommodative, but will be prepared to change course if inflation and, importantly, inflation expectations change.
We will address municipal assets in this commentary; however, we also manage taxable fixed-income, equity, and balanced accounts. In managing equity accounts we utilize exchange-traded funds (ETFs) and actively conduct sector rotation. Exchange-traded funds allow flexibility and generally lower total trading costs than individual-stock portfolios do, and they avoid sales and purchases that mutual funds must make due to funds flows.
The benefits of SMAs have led to their increased use by investors. According to Citi Research, SMA municipal fixed-income assets, both taxable and tax-exempt, have grown from $100 billion in 2008 to $565 billion at the end of Q1 2018. The details are not separately reported by the Federal Reserve, so Citi Research uses a quarterly survey of its customers and certain Federal Reserve flow of funds data to arrive at an estimate.
2008 – Q1 2018: Mutual fund rate of growth has declined while SMA growth has increased
Source: Citi ResearchDirect retail muni assets have declined since 2010 from $1.9 trillion to $1.1 trillion.
Source: Citi Research (SMA + direct retail = Fed flow of funds Households of $1.64 trillion)
Mutual fund performance is affected by fund flows and herd mentality and thus presents opportunities for active fixed-income management. When investors are dumping assets, the mutual fund portfolio manager may not be able to fully practice active management and must liquidate funds as required by redemptions. In these cases, the most liquid and generally higher-quality assets may be sold first in order to minimize effects on net asset value (NAV). Alternatively, when assets are pouring into mutual funds, the increased demand for assets, resulting in higher prices, can present a selling opportunity for SMA managers.
Closed-End Funds and Exchange-Traded Funds
Closed-end funds (CEFs) have been around for a long time – since 1893! This was years before the first mutual fund or open-ended fund – Massachusetts Investors Trust was established in 1924. As the name implies, closed-end funds are closed: They operate with only the funds they raise in the marketplace and have a fixed number of shares. CEFs have a net asset value based on the assets in the fund, but shares in a CEF are traded on an exchange so the price can vary from the NAV. In addition, CEFs can use leverage. By comparison, exchange-traded funds (ETFs) are relatively new: They originated in Canada in the 1990s. They differ from CEFs in that there is not a fixed amount of assets, and the number of shares can change. (For more detail on ETFs see Cumberland Advisors’ revised second edition of From Bear to Bull with ETFs, which discusses mostly equity ETFs).
Municipal CEF holdings were $87.3 billion, or 2.3% of all municipal holdings at the end of Q1 2018 and they have bumped around that level for years. Municipal ETFs are a smaller segment of the market but have been growing recently to $30.7 billion (0.8% of municipal holdings) at the end of Q1 2018 from $19 billion in 2013.
Algorithmic trading in the municipal market
The effects of algorithmic trading in the municipal market are being closely watched by market participants. These algorithms use actual trade data as well as observed bid and ask spreads, ratings, sectors, volume, and any other data the developer of the algorithm finds predictive. Hedge funds were the first market player to use this type of trading. It is used most frequently for trading odd lots (trade sizes below $25,000), where spreads are generally wider per unit of risk and the algorithms can take advantage of mispricing in the market. The municipal market is large at $3.84 trillion at the end of Q1 2018 and consists of over 80,000 issuers that can issue many types of debt and issue sizes ranging from $75,000 to finance a fire truck to billion-dollar issues for major city projects. Market observers that I talk with think the ‘algo’ traders provide liquidity to the marketplace, and they wonder what would happen if hedge funds/algos were to leave the market. However, the use of algorithms is growing, and many trading floors employ their own algos while retaining traders and salespeople. Technology can take some of the human element out of equation, but the nonhomogeneous market still requires live human input.
New and revised regulations by the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB) that require the reporting of markups or markdowns on bond trades could increase the transition to SMAs or wrap accounts that charge a flat fee for execution and advice. Municipal bond trading always has a markup or markdown, because there is a spread between the price to buy and the price to sell; previously, however, these markups and markdowns did not have to appear on confirmations. The size of the markup or markdown can depend on numerous factors, including size, complexity, and liquidity. The reporting of the transaction costs is designed to make the trading of bonds more transparent and could generate conversations between clients and brokers or managers. The MSRB’s Electronic Municipal Market Access (EMMA) system (emma.org) is a central repository of information and is accessible by anyone. It provides trade data as well as issuer offering statements and annual and event-driven disclosures. There are specific rules on when and how a markup is reported, so a client may not always see the markup. The rules are new, and guidance is developing, so it may take some time for the industry and regulators to arrive at a standard.
We expect the growth in SMAs to continue because of the benefits SMAs offer in comparison to direct retail investment and mutual funds.
At Cumberland we buy bonds in large lots and allocate positions to individual portfolios, which allows for better execution and pricing for our clients compared with individual trades for each client.
Cumberland has been able to take advantage of oversold situations during times of stress such as the Meredith Whitney incident (2010), the “taper tantrum” (2013), President Trump’s election (2016), and the excess supply at the end of 2017.
Cumberland’s policy of investing in high-quality bonds improves liquidity and the ability to execute an active strategy. At the end of last year, the huge volume of supply as municipal issuers rushed to access the bond market before the tax law changes went into effect (see John Mousseau’s piece www.cumber.com/tax-free-munis-continue-to-perform/) resulted in higher yields on municipal bonds and a buying opportunity.
Retail accounts do not enjoy the economies of scale that are available to an SMA manager. In addition, active SMA managers that practice total-return investing may have credit-research resources and relationships with many broker dealers that allow them to achieve competitive execution and develop strategies to optimize investment holdings to meet individual clients’ needs.
Some argue that while mutual fund shares can be purchased and sold any day in any amount, an SMA account has many individual holdings that may take longer to sell. However, when an investor sells shares in a mutual fund, the price received is calculated at the end of the day based on the net asset value of the fund. If an investor is instead invested in high-quality liquid bonds like the ones Cumberland purchases in its accounts, then barring an extraordinary event in the market, there should be ample liquidity, and the bonds will be sold at a time that maximizes price. Additionally, knowledge of our clients’ needs has Cumberland looking ahead to provide liquidity when needed. SMAs may also give every client the advantage of providing the portfolio manager with sectors or categories to be excluded or included, such as “green” or “ESG.” Customization is not possible with a mutual fund.
Separately managed accounts have higher minimum investment requirements than mutual funds do, so they are not available to all investors. But as an investor acquires more assets and develops more highly tailored goals and objectives, an SMA may be appropriate.
Finally, the management fee charged on SMA accounts can be affected by the competitive environment. The fee is based on the type of strategy and can be scaled based on the level of assets invested. There may also be custodial fees charged to the account. Mutual funds have an expense ratio, which includes a management fee as well as miscellaneous ancillary expenses, custodial expenses, and a distribution charge. Many have various levels of sales charges. So it is important to look at all expenses when comparing funds.
At Cumberland we continue to operate as our founders did, investing clients’ funds in separately managed accounts. Our approach to investing is top-down and takes account of global interest-rate expectations and credit-quality trends. Accounts are actively managed with a total-return or income orientation, depending on clients’ needs.
Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
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