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Looking Under the SMA Hood

After almost three years, it was over. This past December, Callan Associates, a San Francisco-based investment consultant overseeing asset managers in Charles Schwab's managed account program, removed Chartwell Investment Partner's large-cap value equity product from the Schwab platform. Callan noted that Chartwell had underperformed the median benchmark performance for nine out of 12 previous quarters and occupied the bottom decile for four of those nine quarters.

Was Callan's replacement of Chartwell typical of what happens behind the scenes among the 400 or so asset managers and sponsoring brokerage firms that constitute the separately managed account business? What, specifically, do analysts and consultants look for when studying managers? And, finally, do ongoing performance analysis and manager rotation lead to better results for clients?

The answers to many of these questions are counterintuitive, but then, many things are not what they seem in the expanding world of separately managed accounts.

One of the attractions of investing through a separately managed account is the value that comes from having a group of professionals assess, monitor and select money managers. Instead of using stars or other rating devices to pick mutual fund managers, SMA investors rely on experts for the selection process. According to Eric Davison, a senior vice president at Callan, the firm's entire search and oversight analysis can be summarized by four P's: people, philosophy, process and performance.

At Brinker Capital in King of Prussia, Pa., the operator of a managed account platform for approximately 1,700 advisers, chief investment officer Jim Harrington uses five P's: people, philosophy, process, performance and passion. Harrington, who earlier managed pension investments for Sunoco, U.S. Airways and Crown Cork & Seal, admitted passion may be hard to define, "but you know it when you see it." For instance, when doing an on-site visit to interview managers, if Harrington asks a portfolio manager how much time they have to talk, and they respond they have all day, that's when Harrington gets the sense they have passion.

Although the analyses performed by most sponsoring organizations are similar, there is some variance in the way they tally the results. For example, Smith Barney's managed account platform uses a four-diamond system, with four diamonds being the best and one the worst. SEI Investments, on the other hand, slices and dices data to come up with a numerical rating that runs from one to 100. Mike Hogan, who runs SEI's investment management unit, which includes mutual funds and managed accounts, said managers gaining entry to SEI's platform must score between 80% and 90%. Still other platforms, such as those of Schwab and Brinker, use the equivalent of Wall Street's buy-hold-sell model with a "recommended," "watchlist" or "terminated" status for each manager.

The watchlist status can be problematic: If sponsors are looking for the best managers and getting rid of those that aren't, why is there a middle ground? Glen Regan, who oversees the due diligence of asset managers for Smith Barney's managed account program, thinks it's a bad idea to retain a manager in the middle group. In Smith Barney's four-diamond system, he noted, managers ranking three or higher are recommended and those with two or lower are not.

But other managed account professionals defend the watchlist status. For instance, Brinker's Harrington said, "The general public does not understand why you would stay with a manager when they are trailing the benchmark. If you looked at the three-year performance of some of the very best managers in the world, you might fire them. But if you looked at their five-year performance, you would have wished you kept them." When looking at managers, Harrington said, "you must ride them for an entire investment cycle."

That's the reason for the watchlists. As Callan's Davison pointed out, "Individual investors chased performance in mutual funds and found it was a zero-sum game." The purpose of managed account oversight is to bring discipline to a process that individual investors and their advisers might not have on their own. And such discipline eschews hasty decisions. This discipline, with an emphasis on patience and a long-term outlook, very naturally leads one to wonder about the process that leads to the watchlisting or dismissal of a manager. And that leads right back to the first of the four P's: people.

According to Jack Rabun, who studies managed account platforms for Cerulli Associates, "asset managers are now very aggressive about bringing on new talent. They are hiring teams wholesale away from their competitors." And as asset managers get poached, the assets they formerly managed come under the scrutiny of analysts who want to make sure the performance they thought they were buying into is still capable of being produced.