Author Archives: Barett Ayers

Model-based Separately Managed Accounts (SMAs) are an expression of financial evolution, a step forward from the legacy of mutual funds.

Advisors use tools and technology to help make investment decisions but ultimately must rely on their professional expertise to ensure that the tools are guiding them to the best financial decisions for their clients. Still, the tools that the advisor chooses play an essential role in the success of their clients and their business over the long term. One tool that is increasingly utilized in the investment management universe is the model portfolio-based SMA, which is delivered to the client via an overlay manager . An overlay manager is responsible for trading the model, managing tax exposure and other customizations for the specific client. Using an overlay manager opens some unique opportunities for an investor and represents a step forward as a new and powerful tool for advisors.

Customizable and tax-efficient , model-based SMAs are an advancement above the legacy of mutual funds. Removing the mutual fund wrapper allows a model’s strategy to be more applicable to a client’s unique tax situation, and likely offering cost savings. Essentially, a model-based SMA investors can reach into the model to pick and choose which tax-lot to sell – thereby optimizing the after-tax impact. Mutual fund holdings, on the other hand, ignore an investor’s unique tax profile and will generate capital gains distributions, even for long-term investors.

Coordinating multiple model-based SMAs in a single, cohesive account (such as a Unified Managed Account (UMA)) is the job of the overlay manager, who receives trading signals from model providers. This team of Overlay Manager + Model Provider helps support the advisor by executing the model provider’s strategies alongside individualized account-level client needs.

The advisor is the key here, as the advisor knows the client. The overlay manager and model provider are the outsourced solutions that help give the advisor the best chance to deliver on the client’s financial goals. To learn more, visit http://www.adhesionwealth.com/.

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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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Why Congressionally-mandated FIFO accounting will adversely impact your clients – and what you can do about it.

This past Saturday morning, the Senate passed their version of the Tax Cuts and Jobs Act bill. One of the lesser known provisions in the Senate bill, was the elimination of an investor’s choice to identify which shares of securities they may wish to sell or donate. The provision states that the only way securities may be disposed of is through use of an accounting method commonly referred to as First-in First-Out (FIFO) where the oldest shares purchased are the first ones an investor may sell. Because of the protracted appreciation of the securities market, the first shares purchased are likely to be the lowest cost and therefore carry the most gain (and resulting tax penalty).

The House version did not include this particular provision. And because there exists so many differences between both versions of the bills, this past Monday, Congressional Republicans went to a Conference Committee to begin reconciliation efforts on the various differences between the two tax bills. Led by House Ways and Means Committee Chairman Kevin Brady, and Senate Finance Committee Chairman Orrin Hatch, there are a number of hot topics that will need to be negotiated – including individual tax rates, the handling of AMT, child tax credits, corporate tax rates and repeals to the Affordable Care Act.

Because of the number of big-ticket and high visibility items included in the bill coupled with the pace the legislation is advancing, some experts fear that the FIFO provision may be overlooked and ultimately absorbed into the reconciled bill as collateral damage to bigger-picture negotiations.

However, we at Adhesion believe that this would be shortsighted as the provision is damaging to the very investors and savers that it is purports to protect. The provision has virtually no impact on the $1.7 trillion funding gap the bill creates as it is currently scored at generating just $2.4 billion over 10 years. As inconsequential as those revenues may sound they don’t even consider the expense side of the equation – no official estimates exist thus far on the offsetting expense associated with infrastructure retrofit needed to operate, report, comply and monitor the changes thrust upon the industry. And it certainly does not consider expenses associated with policing and adjudication of these matters.

Interestingly, the Investment Company Institute, the powerful lobby representing the mutual funds and ETF industry, were granted an 11th hour carve-out reprieve in the Senate bill to allow mutual funds and ETFs to continue to sell specific tax lots within their pooled investment vehicles. It is important to note this carve-out exemption for institutional investors does not extend to those retail investors purchasing and selling these instruments, only how the fund itself accounts for the gains and losses within their portfolios.

We feel there are some other anti-competitive and unwarranted elements in this provision that members of Congress, investment advisors and end-investors should be gravely concerned about. Specifically –

  • When the Senate proposed a carve-out provision that protected the institutional fund companies and ETF providers while ignoring the retail investor class, they created an uneven playing field that is heavily tilted against retail investors. Through this provision, the institutional investor will be afforded a significant advantage as they may exit any tax lot they wish. With the freedom to select tax lots, the institutional investors can sell at will, whereas the retail consumer will be locked-up due to tax costs associated with their low-basis FIFO shares. This sort of unfair playing field is analogous to suggesting institutional investors can trade commission-free yet retail investors must always pay commission. The provision creates an enormously unfair and artificial trading barrier that will heavily disadvantage retail investors.
  • With this barrier in place, end-investors will likely open up different brokerage accounts or have paper certificates issued to them. In both cases, there is no reasonable method to enforce or monitor for this type of behavior. This will drive up operational costs for advisors and custodians which will ultimately be passed through to the end investors. And by exploiting this loophole, the revenue projections for this provision are likely to fall even shorter than expected.
  • By adding friction to the retail investor’s ability to liquidate securities through a FIFO provision, one should assume that there will be less selling – which leads to less liquidity and efficiency in our capital markets. This also means that retail investors will be less inclined to eliminate assets in an attempt to seek diversification. This will ultimately lead to concentrated and highly appreciated holdings in client portfolios which runs in stark contrast to tried and true investment principles of diversification, rebalancing and buy-low/sell high for retail investors. This introduces the potential of an enormous loss during a market correction as well as introducing excessive levels of portfolio risk – all while stifling the efficiency of the capital markets.
  • This provision disproportionally burdens older investors who likely have a more extensive tax history and on average maintain a lower cost basis than younger investors. This FIFO tax also represents an unplanned expense that retirees had not budgeted for – which will erode retirement savings at a time when retirees have very little time to recoup this new, unanticipated retirement gap.
  • This provision also disproportionally disadvantages middle- and upper-income investors who are more likely to hold FIFO-eligible securities. Contrast that with ultra-high net worth and institutional investors who frequently hold real estate, hedge funds and other sheltered ‘accredited investor’ assets, which can be exempted from FIFO provisions as a result of the Senate’s proposed carve-out clauses.
  • Lastly, if legislation is advanced, one unintended consequence facing mutual funds and ETF providers is that retail investors will likely seek to avoid concentrated positions so as to have more choice on which shares to dispose of. Mutual funds and ETFs are pooled investment vehicles, and as such, they are generally far more concentrated in a client portfolio than individual equities. We believe advisors and investors will wisely consider diversifying out of concentrated mutual fund and ETF holdings into a larger basket of diversified equities so as to have multiple tax lots to sell. So rather than purchase Coke multiple times, an investor may consider purchasing Coke, Pepsi, Dr. Pepsi and Constellation Brands. Security prices and equity valuations may no longer be dictated based on rational, sound fundamentals, but rather from a desire to exploit loopholes in heavy-handed government legislation.

For a bill that is intended to promote simplification and fairness, we think it does just the opposite. It unfairly penalizes the retail investor with a FIFO tax while introducing liquidity friction and complicated recordkeeping. At the same time, it rewards the large institutional and ultra-high net worth investors with flexibility to use their own preferred inventory accounting methods. Most would argue that if framed properly and viewed in its totality it would be difficult to defend.

So what can you do? We think this particular provision just needs a bit of sunlight so that it can be evaluated and debated in the open. With enough voices we think we can make this happen and we encourage you to get involved.

First off, encourage your clients to take action.  Consider directing them to TD Ameritrade’s Legislative Action Committee site, which has done a fantastic job of highlighting the issue.  From this site, they may contact their local representatives .

Next, as investment fiduciaries we would urge you to read the Money Management Institute’s position on the Senate version of the tax reform legislation.  On their site, the MMI chairman, Craig Pfeiffer shares talking points and a number of template letters you can use to contact your elected officials.  Similarly, the Investment Advisor Institute – an advocacy group for SEC-registered investment advisory firms has developed a site to contact elected officials and communicate your concerns of FIFO legislation.  Adhesion has also drafted an open letter to Congress which can be found here.  Feel free to use it or modify it and share it with your elected officials.

Also, as we head into year end, consider generating losses through active tax harvesting.  These losses can be used to unwind concentrated mutual fund or ETF holdings or buffer against future taxable gains resulting from potential inflexibility associated with this bill.  For more information on the value of tax harvesting and how it can add value to a client portfolio, feel free to watch this webinar

Lastly, we think now is a good time to dump concentrated mutual fund and ETF holdings to spread those proceeds into a diversified pool of equity holdings.  If you are interested in active equity managers, please consider Adhesion’s Asset Manager eXchange which can be found here.

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Why Goals-based is not code-word for ‘ignore performance’.

There is a lot of confusion about what it means to deliver and receive a goals-based investment solution.  Most retail investors believe ‘goals-based’ is simply another attempt at dismissing under-performance.  Or at least so says a recent study cited by Wealthmanagement.com.  In the article, the study indicates that clients believe that “Goals-Based” equates to Performance.  We think it means much, much more.

Part of that disconnect can be attributed to our track record as an industry of wrapping otherwise straightforward ideas in jargon and arcane statistics.  Perhaps another cause of confusion is that many advisors simply do not have the wherewithal to architect, deploy, support and maintain a true goals-based framework.  At Adhesion, as we spoke with our advisory clients, we quickly came to realize that their clients were asking for investment solutions that not only identified where they were on their path to their goals, but also adjusted based on how they progressed on their objective.  We found that many so-called Goals-Based programs that were out there were largely theoretical and academic in nature – making them, at best  – unimplementable by most advisory firms.  We also found that many programs – in addition to missing the upfront and ongoing diagnostics of the client to their goal –did not take into consideration real-life factors like taxes, expenses, downside protection and real-life spending rates.  And for those that did, the cost and accessibility of the program was often prohibitive.

So we are excited to introduce Pathway Portfolios   The suite is comprised of 13 Unique Core/Satellite Portfolios – blending both active and passive investment styles across the three investor lifecycle phases – the Gain Phase, The Protect Phase and the Spending Phase.  The strategies have been built to address the unique challenges associated with each phase of an investors lifecycle:  The Gain Portfolios are designed for investors who are earlier in the investment lifecycle and looking to maximize capital appreciation through a globally diversified portfolio, but while staying within their risk appetite.  The Protect Portfolios are for those investors who are closing in on their goals and looking to achieve some level of capital appreciation yet limit downside exposure, which can be devastating for those approaching retirement (see 2008-2009).  And finally the Spend Portfolios are designed for those who have achieved their goals and looking to accomplish a target spending rate while simultaneously maximizing investment longevity.

The program leverages investment products from a combination of separate account managers, actively managed mutual funds, and passive ETFs and have been engineered to fully leverage the sophisticated Adhesion Unified Managed Account (UMA) platform.

We are excited to share them with Adhesion advisors who custody assets at TD Ameritrade, Schwab Institutional and Fidelity.  Please visit gotopathway.com to find out more.

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