The Rise of Separately Managed Accounts – 2019 Update
Cumberland has utilized separately managed accounts (SMAs) to execute its fixed-income strategy since its inception in 1973, long before SMAs were popularized in the early 2000s.
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
What exactly is an SMA? Per Investopedia: “A[n] SMA is a portfolio of assets managed by 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.”
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 this year are the growth of Registered Investment Advisors (RIAs) and new disclosure platforms for municipal issuers and investors.
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, or that positive returns are greater than the benchmark’s.
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, supply and demand, coupon structure, 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 38-year rally in the bond market and yields continue to decline, 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 coupons 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. In John Mousseau’s August 2019 “The Bond Conundrum and How to Manage” (https://www.cumber.com/cumberland-advisors-market-commentary-the-bond-conundrum-and-how-to-manage/), John notes that “We continue to manage Cumberland total-return bond assets in a barbell method, accenting both shorter-term securities for liquidity and longer-term bonds to lock in yields, with what have been non-Treasury securities in the taxable world and longer tax-free bonds in munis. Indeed, with the fast rush down in Treasury yields, longer-dated munis, though at historical lows, offer value when you can get 3% higher grade in a world where long Treasuries are at 2%. We will take our chances with 160% yield ratios, knowing that defensiveness is built into the cheapness. The front end of the muni curve is VERY expensive relative to Treasuries, so even with a barbell and very low nominal yields, it’s been prudent to have exposure to the longer end of the market.” (To be added to our distribution list, go to cumber.com and sign up or send an email to me at [email protected].)
We 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 more 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. We will consider using fixed-income ETFs in smaller balanced accounts to get the benefit of diversification.
The advantages 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 $593 billion at the end of Q4 2018 and expected holdings of $605 billion at Q4 2019. 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. Note that the rate of growth of SMA municipal assets has been greater than growth in direct retail and mutual fund municipal assets – but pay attention to the scale. For example, direct retail is still almost double SMA assets.
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 results in higher prices and can present a selling opportunity for SMA managers.
Supply and demand can have an effect on bond performance. The currently low municipal supply is partly due to changes in the Tax Cut and Jobs Act that no longer allow municipalities to refinance certain bonds, as well as to high demand from investors in high-tax states and “cross-over” buyers that have become more familiar with the US municipal bond market. Municipal bonds in general have higher ratings than and less correlation to corporate bonds, as well as higher yields compared than other worldwide offerings.
Growth of Registered Investment Advisors
RIAs cater to an eclectic group of clients that include but are not limited to high-net-worth individuals, family offices, corporations, not for profit institutions, and retirement plans. They tend to be partnerships or corporations but can be individual advisors, which are referred to as IAs. RIA assets (including all asset classes, not just municipal bonds) have grown faster than any other retail channel in the wealth management business. According to data collected by Citibank, in 2014 wire houses had 37% of retail assets, which declined to 30% in 2018 and is projected to decline to 28.5% by 2022, while RIAs’ share is expected to increase to 31.4% in 2022 from 27% in 2010 and 30% in 2018.
Disclosure
Bondlink (bondlink.com) and Munite (Munite.com) are new entrants into the municipal disclosure space, catering to the needs of issuers and investors using new, interactive technology. These entities are user-friendly and provide a convenient link to the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access (EMMA) system (emma.org), which 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. Where Bondlink and Munite differ from EMMA is that they provide tools for issuers to more easily reach out to investors. They provide detailed information that analysts require to conduct analysis, as well as links to issuer websites, rating agency reports, and other information. Users can even set up alerts for events filed by municipal bond issuers they want to follow.
We expect the growth in SMAs to continue because of the benefits they 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 doing 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.
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 client’s needs.
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 generally have higher minimum investment requirements than mutual funds or roboadvisors 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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