Taking action: Implementing your written investment plan. BITING THE BULLET part 3

7 Jan

‘Separate account portfolios’ differ from most common in­vestment accounts with a stockbroker in that it is rare for bro­kers to be qualified or licensed to manage accounts on a discretionary basis. According to securities regulations, brokers must ask for and receive consent on every transaction in a cli­ent’s account before executing that transaction. Failure to do so is the practice of ‘discretionary trading’ by stockbrokers and can lead to not only serious penalties, but also, in extreme cases, the removal of their license to practice.

Over the long term, research has not shown any significant difference in performance between professionally managed separate account portfolios and mutual fund portfolios. Both can be used to implement an investment strategy effec­tively. However, some major differences between the two approaches should be considered when deciding between them.

Some of the differences between separately managed portfolios and mutual (or pooled) fund portfolios are outlined below.

Availability to the individual investor: Until recently, inves­tors with smaller portfolios were unable to access the services of professional money managers and were often limited to pur­chasing mutual funds. Professional money managers typically establish minimum account size restrictions; these restrictions have been beyond the scope of all but the most affluent individ­ual investors. On the other hand, the minimum amount re­quired for an initial mutual fund purchase has decreased as the popularity of mutual fund investing has grown over the years, and some funds now require as little as $500 to buy in.

Separate account managers have traditionally focused on providing services to institutional investors, managing the size­able portfolios of defined benefit pension funds and large en­dowments. Most accomplished managers have an account size minimum of $1 million or more. As their reputation and track record improve, a manager may continue to increase their ac­count minimum. Some separate account managers may com­mand minimums as high as $50 million – far beyond the reach of the majority of investors.

A relatively recent development has led some of these man­agers to begin accepting accounts as low as $100,000 when the responsibility for sales, marketing and client servicing is as­sumed by another organization, such as a brokerage or consult­ing firm. Money managers now realize that defined benefit

pension plans are on the verge of extinction as newer corpora­tions are choosing to opt out of establishing pension plans be­cause of the increasing administrative costs of running them and increasing potential legal liability. These corporations are more often embracing what is known as the defined contribu­tion market, where assets are employee funded and managed.

Suddenly, the burgeoning ‘high net worth’ baby boomer market is becoming more enticing to professional managers who traditionally have managed pension funds. Just as sud­denly, the trust companies, insurance companies and banks, who are the traditional purveyors of services to high net worth individuals, have experienced heavy competition and have been forced to re-evaluate their often antiquated models of cus­tomer service and reporting.

Despite the relatively new availability of professionally managed separate accounts to individual investors, each inves­tor must still decide whether this type of portfolio management is more appropriate for them than purchasing mutual funds. Customization: The degree of customization available within a mutual fund portfolio is usually very limited. All unit holders of the mutual fund hold exactly the same units with exactly the same assets that reside within the portfolio. Separately man­aged accounts offer more flexibility, allowing each client to place their own constraints on a portfolio, permitting a greater degree of customization.
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As an example, if you have a request of an ethical nature, such as not to invest in companies promoting the use of tobacco or alcohol, a separately managed portfolio can accommodate these requests, whereas a mutual fund would never change its stated mandate for one unit holder alone. Costs: Most institutional investors, as well as increasing num­bers of affluent individual investors, favour separate accounts over mutual funds because the amount paid by unit holders to cover the costs of administering mutual funds is directly propor­tional to the number of units held. Therefore, an investor who holds a large position in the mutual fund subsidizes the costs for smaller investors. With professionally managed separate ac­count portfolios, the fee charged to investors with larger portfo­lios is a smaller percentage of the assets that they have placed with the manager.

Audits: Mutual funds are required to be audited by independent accounting firms. Separate account managers are encouraged to have performance results audited, but this is not required by law. Information and performance data are also more readily ac­cessible on mutual funds than on private account managers. Tax planning opportunities: With a separately managed ac­count, a taxable investor has some degree of tax planning flexi­bility. At the year end, a money manager can be instructed to sell off stocks that have dropped in price so as to capture invest­ment losses and offset investment gains realized in the portfolio in that tax year or previously. The stocks sold can be repur­chased again after 30 days to maintain the integrity of the manager’s portfolio and effect a ‘tax swap’. Phantom tax gain: Imagine that yesterday you became the owner of a given mutual fund, and that today the manager of that fund sells a particular stock that was held in the fund for several years. Suppose the stock was purchased at $30 per share and sold at $75 per share, resulting in a significant capital gain. For you as the investor, there existed an unrealized capital gain tax liability when you bought into the mutual fund. Because all investors who hold units of the mutual fund on the day the capi­tal gains distribution is declared are hit with the same capital gain, you will participate in shouldering the tax burden of gains even if you bought in after the gains occurred. Fund liquidation and purchases: Besides managing the securi­ties portfolio of the mutual fund, the fund manager must con­tend with purchases by new investors and liquidations by existing shareholders. This can become a problem when major market movements occur and the unit holders of the fund begin to ‘follow the herd’.

Rather than being able to purchase more securities at a dis­count in a down market, the manager may be forced to sell secu­rities at fire sale rates to come up with the cash to cover liquidations, further depressing the net asset value of the mu­tual fund. Managers may at times hold a larger cash position than they would like in a fund because of the need to meet po­tential liquidations.