Understanding the Impact of Two Different Approaches to UMA

Is your firm considering outsourcing your investment management process?  Confused about what a Unified Managed Account (UMA) is as well as the various approaches used to drive this account?  If so, this blog is a must-read. 

A UMA is a highly versatile account that can hold multiple asset managers across a variety of security types.  It allows for mass personalization without sacrificing scale all while delivering the solution at meaningfully lower all-in costs than other programs. And most exciting is that it is an advanced form of outsourcing, so the operational and management burden is all wrapped into an “overlay fee”.

 In order to make the account run, a quarterback generally sits atop the program to coordinate all the activity, referred to as an Overlay Portfolio Manager – who oversees activity ranging from manager trades, cross manager rebalancing, security swaps within the portfolio to avoid excessive trading, cross manager tax management, tax harvesting, client restrictions, client personalization, cash management as well as a host of other day to day administrative tasks.

Adhesion has been in the business of offering our UMA program with overlay portfolio management for 12 years and have helped build and administer thousands of UMA programs for our clients.  Our platform is an open architecture program – which means that advisors have the freedom to ether build their own multi-manager allocations or use one of our pre-built portfolios that have been constructed by a 3rd Party Outsourced CIO (OCIO) or Investment Strategist. 

When evaluating a UMA Platform like Adhesion, it is important to ask detailed questions about approach and methodology because it will impact your client’s experience.

But to understand approach, let’s first define how managers and products co-exist in a UMA, because that’s really where an Overlay Manager earns their money.  It’s also what makes things really complicated and even a bit controversial.  Every security model within a UMA is called a ‘sleeve’.  If you were to put an equity SMA and a single mutual fund together in an account, that would be two sleeves.  Or if you combined three SMAs, two ETF strategists and 1 mutual fund – that is 6 sleeves.  Where the debate begins is how to keep those ‘sleeves’ segmented or ‘Partioned’.  The two methods to partition a UMA and the impact of the approach is really important as it will affect your client’s performance, taxes, fees paid, risk policy adherence, overall account dispersion as well as the reputation of both your practice and the managers firm.

Partitioned Sleeve Based.  A partitioned Sleeve Based Platform tracks individual tax lots to the manager that purchased those positions within the UMA.  We call it Tax Lot Tagging, and the tax lot lives forever with the manager. Each tax lot inside of an account must be explicitly tagged and associated to a manager’s model.  This means that if IBM is held by two managers, the method to assign them is based on the actual trade that was generated by the respective manager.   It allows us to explicitly compute taxes, performance, fees and gain/loss against the manager in which it was earned.   It ensures that when we trade a specific tax lot for the manager, we communicate ‘versus purchase’ instructions to the custodian so their books stay in synch with ours.   It is by far the most complicated method of overlay management.

Blended Sleeve Based.  Sometimes called a poor-man’s sleeve-based system, a blended methodology allows a platform to form a sleeve based on today’s holdings.  There is no tax lot tagging or sleeve-based account and thus there’s no historical record of where the tax lot came from.  This means what a sleeve looks like today is different than what it looked like yesterday. 

After spending much time researching the impact of these two approaches, an industry veteran once summed up the difference this way :

“…think of one of those big popcorn canisters you get during the holidays with the three segments for different flavors.  The segments are basically partitioned sleeves.  You can easily see how much caramel corn is left and how much has been eaten relative to the cheese popcorn.  Now take that divider out, shake the can and try to give your friend half of each flavor.  Now that’s what it’s like to manage a portfolio without partitioned sleeve”. 

To help visualize this issue, we have provided a real life demonstration below that illustrates the impact as well as a questionnaire that can be used to do your own due diligence

Partitioned Sleeve vs Blended Sleeves in Action

Consider the following scenario – Manager A and Manager B are equally weighted at 50% in a client portfolio.  In the first month, Manager A initiates a new purchase of $50,000 into ABCD.  From there, ABCD proceeded to grow a bit in the second month, then significantly in the final month  Manager B, evidently noticing the skyrocketing results of ABCD, wishes to window-dress their portfolio going into quarter end and initiates a brand new $40,000 position in the last month of the quarter as well.

SCENARIO I – PARTITIONED SLEEVE APPROACH:

Position Value in ABCD
Target Manager Allocation Month 1 Month 2 Month 3
Manager A 50% +$50,000 $52,000 $60,000
Manager B 50%  $             –    $             –   +$40,000
Total Portfolio 100%   $50,000 $52,000  $100,000

Manager A.  Over the quarter generated a $10,000 gain on the initial $50,000 investment or a 20% return ($10,000/$50,000).     

Manager A

Return                                            + 20.00%

Beginning Market Value                 $50,000

Ending Market Value                      $60,000     (Gain of $10,000)

Manager B.  Over that same period, had $0 gains and 0% return.

Manager B

Return                                            N/A

Beginning Market Value                 $40,000

Ending Market Value                      $40,000     (No Gain)

SCENARIO II  – BLENDED SLEEVE APPROACH:

Manager A Because in the third month Manager B initiates a position in ABCD as well, only 50% of the account’s total position is attributed to Manager A due to the target manager allocation of 50%.  The holding as a whole was up 11.11%, ($10,000 / $90,000)  however because Manager A  only owns 50% of the position are now attributed 50% of the return, or 5.56%

Manager A

Return                                            + 5.56%

Beginning Market Value                 $50,000   

Ending Market Value                      $50,000   (50% of Total Position’s Ending Market Value –  No Gain)

Manager B, Over that same period, were attributed a gain of $10,000

Manager B

Return                                           + 5.56%

Beginning Market Value                 $40,000

Ending Market Value                      $50,000 (50% of Total Position’s Ending Market Value –  $10,000 Gain)

With Scenario II, what may be obvious to those in the money management business is that the manager who took advantage of window-dressing ended up in a better position than the manager who took a risk.  Some have asked does this anomaly encourage managers to window-dress to split profits (and fees) ?

To the layperson, this seems highly confusing and counterintuitive.  Manager A did a fantastic job, added value, yet in a blended environment appeared flat.  Similarly, Manager B just initiated a position yet immediately is credited with a $10,000 gain.  Most investors would errantly suggest you fire Manager A and put more money with Manager B.

The average multi-manager equity portfolio at Adhesion Wealth has 17 positions that overlap.  Portfolios that include asset classes that are overlapping in nature (All Cap, SMID, Global Equity) have a significantly higher incidence of overlap. Imagine the impact above multiplied by 17x across 500 clients. The impact to both a reputational – and perhaps more importantly – a fee perspective – can be dramatic. 

Is your platform taking necessary precautions to avoid improper weighting and fee attribution?

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