What is the best way to combine smaller investment accounts or SMAs?

In the late 1980s, an investment advisory firm raised the issue, “I have too many smaller SMAs. It is inefficient for us to manage each account separately, and there is an administrative burden for trading, account reconciliation and reporting to our shareholders. What can we do?”

In 1988 when the conversation took place, mutual funds and common trust funds were the only real options.  At the time hedge funds, or private investment funds as we prefer to call them, did not really exist. It was not until the middle 1990s that hedge funds became common.

What issues does a pooled investment vehicle mutual solve for a registered investment advisor?

Each separately managed account (SMA) typically requires its own custody and trading account. If a portfolio manager decides that a particular investment is no longer attractive, or if a new investment is identified to add to the model portfolio, every account will have to place a trade. At the end of each month, every SMA will expect a statement showing its activity and performance.

With computers, this can all certainly be done easier than 40 years ago, but there is still a lot of labor, and potential for minor errors.

There is also an issue with performance. If a new client comes on board in June, are all the securities in the model portfolio still as attractive? Every client with a different date of becoming a client will have different performance.

A pooled vehicle solves several issues:

• All the trading is done at the investment pool level, far more efficient
• One account to reconcile, tremendous time savings
• New clients buy into the investment fund at the current net asset value (NAV), which very fairly allocates income and capital gains
• Reporting can be as simple as adding the NAV to the client statement at the end of the month

Are common trust funds a good option for pooling smaller accounts?

A common trust fund operates much like a mutual fund from an accounting standpoint. The banking laws require, however, that common fund is “maintained by the bank”, which in regulatory parlance means the bank or trust company has final decision authority on ALL activity of the common trust. The portfolio manager certainly does not want this handcuff, and the bank wants to be paid to be in this role.

When is an open-end mutual fund the best solution?

Open end mutual funds are a tried and true investment vehicle. Because the disclosure is regulated by the SEC and the marketing materials are monitored by FINRA, open end funds are available for all investment accounts. Qualified plans, 401ks, IRAs, individual investors, foundations and endowments can all invest alongside one another and take advantage of the economies of scale that mutual funds provide.

This ability to combine qualified and non-qualified (retirement plan and taxable accounts) in the same pool is unique to investment companies and makes a mutual fund (or an ETF which we will address in another case study) a highly efficient vehicle.

If the investment advisor knows that its marketing strategy and target shareholders include qualified retirement accounts, a mutual fund or ETF is likely the best option. Private funds or hedge funds have a limitation on the number of retirement plan accounts that can be in the fund. Many retirement plan investment policies do not authorize investment in hedge funds. Almost all retirement plans authorize mutual funds.