Managing Your Managed Account

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Today, we are continuing our mini-series on how to get the most out of your financial advisor. In Advice on Financial Advisors, last week’s first part of this series, we covered the necessary basics, such as understanding their business model and its influence on their offering, as well as best practices such as picking the right advisor or negotiating fees.

Today, we want to share our best practices on a financial advisor’s most important offering: the (Separatedly) Managed Account (“SMA”), or as we would call it in German, the Vermögensverwaltungsmandat.

The SMA is the core offering of the wealth management business. Clients decide on their risk and return targets, share their preferences on asset classes and factors such as active/passive management, transfer their desired investment amount, and grant their financial advisor wide discretion on how they manage those funds along the defined guidelines. As discussed last week, it’s the preferred ‘product’ of most advisors, as client relationships can last for years or even decades, and more importantly, because they typically earn their management fees regardless of how many hours of work the management of the client’s portfolio actually takes.

Whether an SMA is fundamentally a good product or not for affluent individuals is a hotly debated topic. Financial advisors argue that they typically know better than their clients how to manage a portfolio, and that they might avoid common pitfalls, such as panic selling. Opponents of the SMA rightfully point to the fact that many financial advisors underperform low-cost alternatives, such as a simple combination of a bond and a stock ETF.

As a wealth management firm that offers SMAs to their clients, the past 5 years of track record so far demonstrate that our offering is worth the fees that our clients pay. But we also agree with the opponents that many, if not most, SMAs offered by financial advisors and private banks are not worth the money. And we’ve made it our mission to ensure that our clients - if they choose to outsource the management of their portfolios to a third party - receive an offering that fulfills three criteria: (1) it fits their goals and needs, (2) is well-constructed, as well as (3) fairly-priced and actually worth its money. Whether that is us or another advisor.

#1: Fitting Your Goals and Needs

Constructing a portfolio according to what a client’s goals and needs are (whether it’s their Investment Objectives, or simply a target return required for them to hit their income and/or retirement goal) should be a simple exercise. Yet unfortunately, we see many, many financial advisors ‘put the wagon before the horse’. In many cases, they simply ask whether a client wants a conservative, moderate or aggressive portfolio, and maybe ask whether they’re interested in special building blocks or not (i.e. single stocks vs. ETFs, alternative asset classes or not). In some cases, they might not even ask questions at all, and just propose one of their model portfolios.

We think that putting implementation first is the wrong way to go. Many entrepreneurs have a risk tolerance that is fundamentally different from what their required risk for their target return is, and hence end up with portfolios that are much more aggressively positioned than necessary (and which doesn’t mean the expected return of the portfolio would automatically be higher) . Worse, some financial advisors don’t ask about such parameters at all: just recently, we won a client who had previously worked with a large private bank, which had never even asked him what his income requirement was, even though ensuring stable, long-term income was his biggest concern.

To make sure that the proposed SMA fits your goals and needs, it’s unsurprisingly helpful to know what your goals and needs are. That might include a Return Target (i.e. reach a certain portfolio size until retirement and/or stable income after tax and inflation), Risk Preferences (whether you care about short-term volatility, maximum drawdown or illiquidity), Asset Class Preferences (i.e. whether you believe in a certain region, don’t want hedge funds in your portfolio or are maybe even just looking for a niche solution in a specific asset class) and lastly, Strategy and Style Considerations (i.e. the debate of active vs. passive management, tax-related considerations or ESG requirements).

Make sure to share those thoughts with your financial advisors, ideally ahead of time - after all, even the greatest advisor can’t read your mind and might otherwise provide you with a generic portfolio. Or, even better, get a financial advisor who will proactively ask these questions by themselves.

#2: A well-constructed portfolio

Now that we know what our goals and preferences are, we can use those insights in the construction of our SMA. It might be tempting to jump directly into specific products, but in most cases, the portfolio design process should start ‘product-free’, and thus begin with the so-called asset allocation, meaning the breakdown of your portfolio into individual asset classes, regions, and styles.

Unfortunately, many financial advisors already ‘disqualify’ themselves in this first step. I’m not surprised if a retail-oriented financial advisor sends me a proposal that is just an unstructured mix of 3 to 5 actively managed funds (likely their revenue comes from their sales retrocessions). But I continue to meet private banks and other UHNW-oriented advisors that send out proposals that are just five equally-weighted active funds with no clear line of reasoning behind their selection.

That doesn’t mean that you have to build massive quantitative models, either. An advisor should simply demonstrate a structured process that clients can follow, thus allowing for a feedback loop on whether a decision along the way might not correspond with their preferences. To name a few approaches that we frequently see and that we’d find reasonable as a starting point:

• You can orient yourself around common portfolio benchmarks. The most frequent one is a 60/40 benchmark of 60% equities (e.g. the MSCI World or ACWI index) and 40% bonds (like a Euro Aggregate Bond index). (Markus would point out that the main reason for it being 60/40 is simply because it sounds more sophisticated than 50/50.)

• You can use global economic datapoints to decide on your country weight from a ‘bottom-up’ perspective. There’s numerous advisors that for example weigh their portfolios not according to market cap but GDP or other global indicators.

• You can work off of quantitative metrics of specific asset classes, i.e. long-term risk, return, or correlation metrics. 

Most advisors have clear preferences in this regard and will likely be keen to argue why their approach is preferable. For you, the more important thing to keep in mind is the influence of their specific framework on the proposal they will make: US banks, in our experience, tend to allocate more weight to US stocks and alternative assets such as private equity, while European banks are often more focused on European stocks, commodities, and real estate. Neither approach is wrong, but be mindful that the approach (which sometimes is also driven by the bank’s product offering) might have substantial impact on your long-term outcomes.

These frameworks are typically just the starting point. From there, managers typically make active decisions on when and how to deviate in a way that in their view either adds return and/or reduces risk in the portfolio. Examples include:

• Country Breakdown and Weights: With the 60/40 approach, an advisor could just buy two ETFs to build your portfolio. Instead, managers typically select multiple funds, ETFs, and/or single stocks to fill the underlying country and sector allocations. They might also over time deviate from these country allocations according to what they deem attractive risk-reward, i.e. overallocating to a country they deem undervalued relative to another.
  

• Sub-Asset Classes: Large benchmarks, like the MSCI World or the Global Agg, are typically biased towards large, established assets and firms, such as the ‘Magnificent Seven’ (Apple, NVIDIA, etc.) or US Treasuries. Many asset managers logically deviate from these benchmarks by adding more ‘niche’ opportunities, such as small-cap or industry-specific stocks, or riskier debt such as emerging markets debt, high-yield bonds, or structured credit.
  

• Non-Benchmark Assets: There are many assets that are not included in the typical 60/40 benchmarks which a financial advisor might still want to add to improve a portfolio’s risk-reward. That might include more niche sub-asset classes such as certain bonds or stocks, but might also mean other asset classes such as commodities, a currency overlay, or alternative investments.

Once again, it’s an advisor’s underlying framework as well as their experiences and preferences that shape your personalized asset allocation. However, unlike the initial framework where there’s often no clear right or wrong, in our view the asset allocation and subsequent implementation suggested by financial advisors often has (substantial) room for improvement. Once again, a number of examples:

• Deviation between Benchmark and Implementation: One of Markus’ favourite, real-life examples. An advisor might use a 60/40 allocation as their benchmark, but then use a 65/35 implementation (i.e. slight bias towards stocks), which would be expected to yield slightly higher returns - which they ‘sell’ as their outperformance and value-add even though it comes through higher risk. → Avoid this by making sure that benchmark and long-term implementation are actually comparable.
  

• No Deviation between Benchmark and Implementation: I see many fee-based advisors (Honorarberater) convince clients by highlighting their unbiased approach and focus on low-cost index funds. In practice, they then take two ETFs (one for bonds, one for stocks), or sometimes just one multi-asset ETF, and charge abhorrent amounts for a portfolio requiring little to no work. (To once again quote a Honorarberater who once proudly told me: “I sell one fund to my clients, see them once a year, and charge one percent.”) → Staying close to an index doesn’t have to be a bad thing - frequently the opposite is true. But if that’s the case, make sure you pay a justified amount, or do it yourself. (More on that in #3).
  
  

• Active Strategies: Despite the ever-growing quantitative proof that most active strategies, especially in public equities, underperform their passive benchmark over the long term, we still see financial advisors and private banks adding them to their portfolio (bonus points for funds/strategies managed by their private bank’s own asset management division). We often see them added to client portfolios to contribute to the illusion of an actively managed SMA even when it is often not actively managed. → We’d be cautious around active strategies. Make sure that your advisor provides you access to low-cost, institutional share classes. And even in the case of the cheapest share classes, ask them to justify why they think an active manager makes sense, despite the evidence to the contrary.

There are many other points that would make this article even longer than it already is. So instead, let’s summarize what we’d expect from a well-constructed SMA: we’d want it to be designed specifically according to your goals and needs (#1). We would want it to be based on some sort of understandable, structured framework (i.e. 60/40, a quantitative approach, etc.) and not their gut feeling. Lastly, we’d want the implementation to be based on a financial advisor’s preferences and strengths, but also under consideration of proven success factors (i.e. lower costs, clear differentiation, only proven active strategies).

To provide a bit of insight into how investment strategies at Cape May Wealth Advisors fit into these criteria:

• We spend a substantial amount of time to initially understand and quantify our client’s goals and needs. Financial planning and asset allocation are an entirely separate step from any product-specific discussion.
  

• 60/40 is outdated. We provide a truly differentiated approach to asset allocation. Increasing the resilience of your portfolio without sacrificing returns can be surprisingly straight-forward. We look beyond the reliance on large-cap stocks and bonds, and diversify heavily across various countries, add niche sub-asset classes, as well as inflation-sensitive assets such as commodities or inflation-linked bonds. Over 100 years of data and five years of track record spanning episodes of recession, growth, high inflation, war and conflict, have demonstrated a significantly more stable performance than a simple equity-bond portfolio.
  

• Passive ETFs - but active risk management. As outlined above, there are countless data points demonstrating that active managers struggle to outperform over the long term in each asset class, and hence, most, if not all of the products in use are low-cost index funds. However, on a portfolio level, actively reducing high-risk exposures in turbulent times has offered the potential to limit losses and increase long-term returns.

If you’d like to learn more, don’t hesitate to reach out. Markus and I would be happy to give you an insight into our SMAs.

#3: Worth The Money

Let us conclude this article with what might be the most important part: sharing how you can make sure that the SMA feels like it’s worth the money you pay. Let’s start with a little anecdote.

As someone working in the single family office space, keeping fees low was always one of my most important jobs. After all, my bosses had hired me to not have to rely on external parties, so if we were going to work with asset managers in the future, I’d have to prove that they are worth their money, and/or had to keep their fees extremely low. Many of my encounters with asset managers left me sceptical of their offering, which in most cases I found not to be worth the money at all. (But there are some exceptions.)

So when I became a self-employed financial advisor, I started with product-free, fee-based advice, as I saw more value-add there than in helping clients manage their ETF portfolio. But I was surprised to see that I had at least partially misassessed the situation: many clients saw even a simple ETF portfolio as a better offering than the terrible actively managed strategies they knew from prior banks and advisors. They were nervous about managing large amounts of money themselves (for someone not working in finance, having to execute a seven-figure ETF trade can be nerve-wracking). And lastly, having me as the manager of their ETF portfolio would mean that they’d have me and my network on their side for all other wealth- and non-wealth-related topics.

Or said differently: ‘Worth the money’ is an extremely subjective assessment. But there are a few pieces of cost-related advice that we can share with our dear readers:

• Overall Fee Structure. Generally, a multi-asset, actively managed account should, in our view, never cost more than 1% p.a. (excl. VAT), especially if you’re an affluent client (i.e. 1M€+ in investable assets). If you’re below 1M€+ and would have to pay more than 1%, it might be better to pick a single, diversified ETF and take care of it yourself - there’s a good chance there’s more opportunity for your overall wealth outside of your portfolio.
  

• Fees vs. Performance. Higher fees can be justified if the offering can generate outperformance and/or lower risk after deducting fees. Ask your advisor to demonstrate why more expensive products in the portfolio are worth their higher fees, and also ask them to justify their fees at the portfolio level. They should be able to demonstrate some (risk-adjusted) outperformance, or at the very least match the benchmark after fees if they provide you with other benefits (see below).
  

• Fees vs. Other Benefits. I’m generally cautious around promises made by financial advisors, especially if they are promises to offset dubious track records in their investment solutions. But there are some non-portfolio benefits that private banks, financial advisors, or multi-family offices can bring that might be included in the fee, such as (preferred) access to alternative investments, lending solutions, or wealth reporting, and that we’d deem worth paying a slightly higher management fee for.
  
  

• Fees vs. Time Savings. As mentioned in my prior anecdote, many entrepreneurs are happy to outsource the day-to-day management of their portfolio to someone whose sole job is investment management - benefitting not only from that person’s expertise but also from being able to free up time for other activities, where ‘return on time’ is likely higher than in optimizing their ETF portfolio.

So to summarize:

If you’re looking to find your ideal financial advisor, make sure not to underestimate the quantitative factors. The SMA they offer you should make sense, should be harder to replicate than with two ETFs, and should offer clear long-term benefits. They should also be fairly priced. 

But perhaps more importantly: trust your instincts. As we mentioned last week, a financial advisor might be your partner not just for a year, but the rest of your life (and maybe then even the life of your children). Hence, you should have a good feeling when you first meet them, when you discuss your goals and preferences, and when you then get to work. If you have a good feeling, fees might almost become a secondary consideration - if you trust them, and feel the cost to be justified, even something we would deem above-average might be worth every cent. 

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