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Morningstar Crowns Stars on SMAs

In the latest sign that separate accounts are truly going mainstream, Morningstar of Chicago has just launched a new star rating system for the investment class. Some said the new service could ramp up interest in the already rapidly growing separate accounts industry, particularly at a time when mutual funds are engulfed in the regulatory scandal.

"I think it could encourage more investors to go to separate accounts," said Tom Meyer, CEO of Meyer Capital, an independent advisory shop in Marlton, N.J., with $200 million in assets under management. "Anything that would help them to use these would make them more attractive. "

Morningstar began providing research on separate accounts about a year ago, and now has some 2,700 separate accounts in its database. A rating of one to five stars will go to 1,200 of these separate accounts - all those that have filed at least three years of consecutive monthly returns and that have at least five separate accounts. The stars will be applied based upon past performance in terms of both return and risk. The separate accounts will also get a separate flexibility rating - based upon more than a dozen features that allow for customization, such as the ability to exclude certain securities from an account, modify sector weightings, harvest tax losses or analyze specific trades.

Morningstar's separate account database represents approximately 90% of the entire retail market and 60% of the institutional separate account market by assets and number of composites. The industry currently claims assets of around $456 billion, and some predict that will double in the next three to five years. A one-year subscription to the Morningstar Principia Separate Accounts database, which provides access to the ratings, costs $1,395 and includes four quarterly updates.

One separate accounts management firm said they were worried that the star rating system might oversimplify the investment class, reducing it to a product rather than a process. "For as long as modern-day investing has been around, people have tended to look for the simple answer," said Jack Sharry, president of the private client group of Phoenix Investment Partners, one of the largest multi-manager firms in the managed account arena (see MME 8/18/03). "And that doesn't necessarily lead to success over time, because the tendency is to look at performance through a rearview mirror.

"Let's say an adviser makes a recommendation. The client may say, Yeah, but I heard Morningstar only rated that a three-star account.' With that knowledge in mind, the adviser may recommend what the star says, instead of what they think is best," Sharry said.

Morningstar Managing Director Don Phillips countered that advisers "can intelligently digest what the star rating does and does not tell them." He expects that advisers will take the ratings into account along with a wealth of other available information. "I would think of the ratings as being additive, not reductive. There are over 170 data points, including different total returns. And we've heard from financial professionals, that they appreciate all the detail but want a simpler view from 30,000 feet," Phillips said.

With wirehouses like Merrill Lynch currently controlling 70% to 80% of separate account sales, independent advisers are increasingly getting into the field, and Morningstar thinks its rating service will make advisers feel even more comfortable with the products.

"Advisers see the theoretical benefits of separately managed accounts, but they're very hesitant to give up the clean and open playing-field of mutual funds, where they have a good sense of how good one manager is relative to their other choices," added Phillips (see MME 10/13/03). "Advisers have said they would have a greater comfort level if there was a freer flow of comparative information."

Meyer said he personally likes to meet with separate account managers himself, and probably won't rely too heavily on Morningstar's new star ratings, but he said that it should serve as a great marketing tool for advisers who are just getting into the business. Meyer uses Morningstar's separate accounts database, as well as Mobius, which also provides data as well as buy and sell recommendations on separate accounts. Some observers claim Mobius and other similar services are slower and more expensive than Morningstar, however.

Copyright 2003 Thomson Media Inc. All Rights Reserved.