The key difference: separately managed accounts are, in essence, individually owned portfolios run by a professional manager for the benefit of the individual, in exchange for fees paid by that individual.
Mutual funds, in contrast, are pools of investment money that are invested by professional managers for the benefit of the larger group of shareowners, paid for by fees that can be levied on the group in a variety of ways.
The two forms of investment ownership offer very different degrees of personal flexibility.
The personalized, separately managed account approach, which is generally reserved for investors who have a substantial gathering of assets - $500,000 or more, in most cases - can carry some advantages, along with, of course, potential drawbacks.
First, the potential advantages:
- Tax efficiency: Each sale of a stock or bond can generate a taxable event in the form of a gain or a loss. Keeping this in mind, managers of separately managed accounts can keep the sales of securities at a minimum in any particular year, enabling an individual's wealth to grow without incurring taxes in that period. Or they can strategically cash out securities for a loss, generating tax savings on income that their investors might have realized in other quarters.
Mutual funds offer no such flexibility. A mutual fund manager may be forced to sell securities at a gain or a loss simply because some investors want to cash out - generating taxable events for all who remain in the fund. Or they may engage in buying and selling for market-timing reasons - events that will generate taxable events for their shareholders whether or not it's to the shareholders' advantage to do so.
- Personal control: The owners of separately managed accounts can exert significant and direct control over the nature of their investments, if they so desire, even though they may have signed over trading authority to a professional manager or management group. For example, if these investors insist on a concentrated portfolio of aggressive investments, that's what they will get. Or they can call for a more diversified mix, and give their managers the flexibility to create it.
Mutual fund shareholders, on the other hand, are bound by the decisions made by their fund managers, even though those decisions may be constrained somewhat by the broadly defined investment style spelled out in each fund's prospectus.
Beware of Costs
Managers of separately managed accounts are generally paid according to a set percentage of total assets held by their clients per year. And that can lead to one of the larger drawbacks of the approach.
A typical managed account will charge the client around 1% of total assets per year. It's important to keep in mind, though, that those fees are automatic fees for the adviser, regardless of whether they spend time on account management. Their financial incentive, therefore, is to do as little as possible in the way of account maintenance, unless the account owner is of a mind to look elsewhere for attention.
Thus, the key take-away points for anyone considering such an arrangement:
- Be sure you need it. Gaining control of tax payments is one of the best reasons for opting for personal management, but this will be a significant consideration only for investors with a considerable pot of assets sitting in non-tax-deferred accounts.
- Be secure with your adviser - and beware. Obviously, you need to be personally comfortable with an adviser before you will be willing to turn over control of your financial investments to that person. Regardless of comfort level, though, don't turn over too much authority. Documents outlining the terms of separately managed accounts should confer the ability to an adviser only to trade - never the ability to withdraw cash or assets.
The Bottom Line
So do separately managed accounts necessarily give you better returns than, say, a collection of mutual funds?
As with any tool, the quality of the result depends largely on how you use it.
High-net-worth individuals who have tax-planning needs are probably the best candidates for a personalized account. Others, who have most of their money already invested in tax-deferred accounts such as 401(k)s or IRAs, might be just as well off to stick with buy-and-hold mutual funds that can deliver returns without the added annual management fees that a separately managed account generally brings.
