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UMAs Take Hybrid Overlay Approach


As the unified managed account business rapidly develops, many firms are recognizing the need to offer UMAs to clients. Once the decision is made to introduce a UMA, sponsor firms then begin grappling with whether to hire an overlay portfolio management company, allow portfolio managers to run their funds independently, commonly known as passive management, or use a hybrid approach.

Overlay portfolio management is an investment management process that takes a holistic approach, coordinating the trading activity of investments such as mutual funds, exchange-traded funds and alternative investments.

"There is a lot of talk about this in the industry now, and the definitions are broad because this is a fairly new concept that is evolving and changing quickly," said Jeff Strange, an analyst with Cerulli Associates of Boston.

According to research by Dover Financial Research of Boston, 14% of sponsor firms opt for the passive approach and 36% employ active overlay management, but the majority, 50%, take the hybrid route

A number of firms, such as Smith Barney and UBS, are opting to hire an active overlay portfolio manager, such as Placemark Investments or Parametric, experts said. These companies work with sponsor firms to develop customized UMA programs, while using the sponsor firms' operational infrastructure, investment managers and products.

"We have seen an incredible pickup in business since the new year," said Randy Bullard, executive vice president at Placemark. Those firms that don't offer a UMA should consider investing in the business, he said.

It works like this: Money managers at the sponsor firm working on different accounting sleeves hand over their investment models to be part of the active overlay manager's strategy. In addition to looking at client restrictions, such as certain stocks to hold or stock diversification, the overlay manager also provides tax management capabilities, explained Jean Sullivan, a managing principal with Dover Financial Research.

Having an overlay manager eliminates wash sales and provides automatic rebalancing and a single integrated account for clients, Bullard explained.

Hiring an overlay manager is a useful approach because it helps firms bring UMAs to market faster, since UMA platforms require specialized technology and knowledge, said Steve Deutsch, director of the separate account business at Morningstar of Chicago.

This approach is especially useful for smaller sponsor firms that may be losing assets to companies that offer a UMA.

"Small money managers and boutiques that have an interest in the UMA marketplace, but have not considered the business due to the expensive infrastructure, can participate without having to go through intensive upfront and ongoing costs," said Matthew Schott, an analyst with Needham, Mass.-based TowerGroup.

Other firms such as Morgan Stanley have adopted a hybrid style, which allows managers to execute their trades independently, but the company has an overlay manager watch out for wash sales and tax-management opportunities, experts said. The underlying argument for this approach is that money managers bring brand intelligence, capital and expertise in investment management to the table, Sullivan said.

Firms that decide to take a passive approach to the UMA need scale, knowledge and a strong commitment to the business, experts said. One advantage to this approach is that it allows companies to retain their fees without having to share them with the overlay manager. It also enables managers to tout their own performance and maintain their brand identity and recognition.

The passive style appeals especially to money managers who are hesitant to change their business practices and feel uncomfortable with the idea of an overlay manager.

Some money managers feel that trading their own accounts is a significant part of their value proposition and do not want to relinquish control or turn over company information to someone else's hands, Schott said.

Also, some money managers have strong relationships with the trading desk. Yet another reason firms may prefer the passive approach is because if an overlay manager cannot faithfully replicate the performance of the money managers, it will reflect poorly on the sponsor firm, experts noted.

However, the passive approach allows for little coordination among the money managers on the client's UMA platform, which can lead to wash sales and inefficient tax investments.

There are instances where an overlay manager may not be the best option for a client, such as trading of micro-cap stocks and fixed income, where best execution is a key factor. Active overlay management is best suited for more liquid investments, such as large-cap stocks and index funds.

If an overlay manager has not traded micro-cap stocks before, they may not be familiar with how to achieve the best execution, which is very important with micro-cap and small-cap stocks, experts said. In these instances, if a company has an active overlay manager, it may be best for them to allow the money manager on that particular sleeve to continue trading or ask them for guidance on the trades.

With growth projections for UMAs so high, more asset managers are likely to enter the business. UMA assets are expected to reach $29 billion this year, up 21% from $24 billion in 2001, according to Tiburon Strategic Advisors. And by 2011, they are expected to reach $117 billion.

In the end, Strange said, no one approach to overlay portfolio management will win out completely, but managers will decide what to do depending on their investment management style and what is most conducive to the company.

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