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SMAs Conflicted on Fund Scandal Fallout

If you sell brick houses, and the wooden houses next door catch fire, it's natural to see a marketing opportunity in your future.

But financial advisers and separately managed account experts are divided about whether the current mutual fund scandal provides a marketing opportunity for SMAs. Scott MacKillop of Trivium Consulting in Evergreen, Colo., says he had a sort of "visceral reaction" when he first heard the idea, that it would just be asking for trouble.

First, he says, there's "sort of an unseemly quality about kicking a whole industry."

Second, "you just can only imagine that there's some equivalent that just hasn't been discovered yet on the separate account side. You don't want to be too strident in that area and have your number come up the day you launch your new marketing campaign," he said

Gary Gensler, a former assistant secretary of the Treasury in the Clinton Administration and author of The Great Mutual Fund Trap (see MFMN 10/14/02), doesn't see the scandals providing much of a boost for separate accounts. The fees on separate accounts amount to much more than anything lost through market timing, he says.

But some advisers who use mutual funds say that this common perception of SMAs as a higher-cost product than mutual funds is based more on the way mutual funds are reported than actual cost differences.

Lewis J. Walker, president of Walker Capital Management in Norcross, Ga., notes that mutual fund transaction fees and a number of other costs are not included in the fund expense ratios, although they often equal the whole amount.

"If you take the average adviser who's taking 1%, add it to the internal cost of those no-load mutual funds, you have a fairly high-cost money management discipline compared with separate accounts," Walker said. In his practice, Walker said, the 80-98 basis points he charges for a separate account, along with the 50 basis points for the manager and 50 for the platform provider, are still equal or less than the true costs of mutual funds.

Vern Sumnicht, president of Sumnicht Financial Advisors in Appleton, Wisc., said the scandal may expose hidden transactional costs, making it difficult, in turn, for the majority of advisers to continue using no-load mutual fund programs. "That would make the model that most advisers use very difficult to sell," he said.

John Bogle, former president of the Vanguard Funds (see special guest Q&A with Bogle, page 8), has claimed that one-third of a typical fund's returns are skimmed off by the mutual fund industry - what he has called "the mutual fund casino."

Regardless, MacKillop acknowledged it may be a good time for separate account platform executives to sell financial advisers on the advantages of separately managed accounts - "but I think you have to be pretty subtle about this," he added.

"I think from a transparency point of view, they definitely have an advantage," MacKillop said. "As a person who owns separate accounts, I can attest to the number of confirms you get in your mailbox every week. You definitely know what you're holding."

Going Mainstream?

Will the scandals create market pressures that will turn SMAs into a mass-market product? Advisers say no. But MacKillop is unsure.

"This is still an issue that has yet to play out. Curian has lowered the minimum to $25,000, but it's a little hard to tell today whether that's something that's going to grab hold in the market place or whether that's too low."

"If people knew this," Sumnicht said, "I think many, many more people would move to separately managed accounts. The problem is there's a very large deception here. When it's a deception of up to 50% of the cost not being disclosed and people believe that they are, I believe this is serious."

Sumnicht continued: "One of the companies I went to was a trucking company. These are guys with leather jackets and chains and they park their Harleys out in front.

"These are not your guys who sit around worrying about which mutual fund to be in, you wouldn't think, but I no more than got my stuff set up and barely opened my mouth, [when one trucker asked], Hey, you don't have us involved in any of them mutual funds that are all screwed up there do you?'

"I didn't expect that, but they were all quite aware," Sumnicht said.

Whatever - and whenever - the outcome of the mutual fund scandal, Sumnicht also predicts that the current level of public awareness in mutual funds' shortcomings will eventually pass.

"How long do you think everybody is going to remember this? How many people remember that virtually every brokerage firm in the country was indicted for fraud and paid a billion and a half dollars?" he asked.

"So, three months from now, maybe six, unless they continue to keep finding things, my guess is that this will blow over and that will probably be the end of it," Sumnicht said.

And there also seems to be some evidence that there's simply no need to provide the high-net-worth market with a hard sell on the virtues of separately managed accounts. A recent poll conducted by Spectrem Group found that in the ultra-affluent market - households with more than $5 million in net worth - only 6% of investable assets are in mutual funds.

Bennett Voyles is a contributor to SMA Advisor, a publication of Thomson Media's Financial Planning magazine, who has worked for The Economist and holds an MBA from New York University's Stern School of Business.

Copyright 2004 Thomson Media Inc. All Rights Reserved.