Sizing Up the Separate-Accounts Opportunity

Not long ago, entering the term "separate accounts" on an Internet search engine produced dozens of Web sites offering financial advice to couples with failing marriages. But times have changed. Today, that same search produces hundreds of references to an investment vehicle whose appeal is spreading like hot gossip.

No search engine, of course, can evaluate whether separate accounts are right for your customers or how to enter or expand this business. However, financial institutions searching for differentiation and growth may find that offering customers separate accounts is a winning strategy.

Expanding Market
A separate account is a professionally managed portfolio of individual securities. Just a few years ago, they were the privilege of the ultra-wealthy. But technology, reduced operating costs and fierce competition has reduced the price of admission - greatly expanding the potential market. Account minimums commonly at $1 million just a few years ago, have widely fallen to $100,000 and lower.

Often compared with mutual funds, separate (or managed) account programs offer customized portfolio management for an asset-based fee. Separate-account enthusiasts cite several advantages over mutual funds, including:

Customization - The portfolio of stocks and bonds is tailored to the individual's need. Clients may choose to not hold a particular company or industry in their portfolio for personal, ethical, or economic reasons.

Tax efficiency - Money managers can time a client's trades for optimal tax treatment based on the client's specific needs.

Stability - A separate account by definition is not subject to the effect of cash flows from other investors, as in a mutual fund, that can sometimes force managers to take steps that impede the fund's return.

"All-in" cost - Most separate-account sponsors charge a simple fee based on assets under management, rather than discreet fees for each service (such as advice and trading commissions). In addition, the fee tends to decline as assets under management increase.

The popularity of separate accounts goes hand in hand with the recent growth of fee-based investment advice. While mutual-fund assets currently dwarf total managed-account assets, sophisticated investors are increasingly searching for a more personalized alternative. Many formerly self-directed investors, bewildered by today's turbulent financial markets, want the assistance of an investment professional and are willing to pay for it.

Driving Growth
Growth rates for separate accounts are outstripping mutual funds, with more of the same forecast. Assets in separate accounts - totaling about $415 billion in 2001 - have more than doubled over the past five years. Financial Research Corp. projects separate-account assets to more than double again over the next four years - approaching $1 trillion by 2005 - and totaling nearly $3 trillion by 2011.

Changing demographics are also driving the separate-account boom. The past decade's bull market created an explosion of wealth, particularly among aging baby boomers that are looking to maximize and pass along their estates. Around 80 million people worldwide owned more than $100,000 in financial assets in 2000, according to Celent Communications. These ranks are projected to swell to 130 million by the end of 2005, with total worth of nearly $70 trillion, a third of it in North America.

Many bankers and analysts agree that separate accounts represent a major growth area of banking and asset management over the next five years. Until now, major Wall Street brokerage houses have dominated the separate-account market. But a wider array of investment professionals is entering the fray, including banks, mutual funds, financial planners and insurance companies. The window of opportunity will not last forever, however, because competition for the business of high-net-worth (HNW) individuals is soaring.

Carefully Analyze Options
Executives at growth-starved financial institutions should be asking three questions:

- Should we pursue the separate-accounts business?

- How intensely should it be pursued?

- What platform and business model should we use?

We suggest the following thought process in considering these questions:

- Are we in the asset-gathering and/or wealth-management business? Institutions following this strategy should seriously consider separate accounts, particularly now when just a relatively few large financial institutions have major programs.

- What's the best way to take advantage of our core competencies?

- Banks - Do we have the needed distribution network, including skilled personnel such as financial advisers that are compensated in a way that motivates them to sell separate accounts? Compensating the customer-facing salesperson through traditional bank methods - typically salary plus annual bonus - is a recipe for failure. For most banks, the key to success is the proper use of their distribution/sales channel.

- Insurers - Are separate accounts the way to change the market's perception of our company from a provider of assurety and financial-protection products to a wealth-management/wealth-creation company?

- Brokerages - Can our sales culture handle the need to shift broker/financial adviser compensation from a transaction/commission basis to an assets-under-management fee?

- Money managers - How can we thrive as margins narrow, especially if we have to compete against established players?

- Is this going to cannibalize other parts of our business? Almost certainly. Affluent and HNW investors will continue to convert their mutual-fund holdings and brokerage accounts to separate accounts - the question is whether they will do it with you or with your competition. As Intel has demonstrated so successfully with personal computer chips: better to keep customers and revenues within your company - rather than at a competitor's.

Should we use open or closed architecture? The answer depends largely on your strategy. A major effort to build a multi-billion-dollar business will require open architecture so that you can connect easily with the wide variety of asset managers (and other vendors) that your customers will demand. Affluent and HNW investors want choices that closed-architecture programs don't allow.

Can we start slowly and cheaply, scaling later? While an option, it's a risky strategy. You can dip your toe in the water and wait to see how things play out. But those that jump on the separate-accounts train with a solid plan and commitment may leave you behind, reducing your odds of ever reaching critical mass.

Technology Influences Strategy
Technology will influence your separate-accounts strategy. Here are three options:

You can enter the business using off-the-shelf products that provide quick, low-cost entry. However, these packages have some distinct drawbacks - there is no product differentiation (your product looks just like your competitors), they are difficult to scale, and they typically limit choice of managers. This option makes sense for financial institutions that don't expect separate accounts to become a major business but still want to include it in their customer offerings.

You can develop your technology in-house. That will give you complete control of the business and retain profits. But this path can be expensive and slow, and it requires management attention and specialty skills that are in short supply.

You can outsource, which also allows quick, low-cost entry. This option may provide the differentiation, scalability and broad selection of portfolio managers needed to become a scale player. However, you will have to assess whether the value delivered by the provider is worth the trade-off - sharing a portion of the fee income with the provider.

Be forewarned: compared with the mutual-fund business, separate accounts is a difficult field to enter. The accounting and record-keeping requirements are much stiffer, experienced personnel scarce, the customer base more demanding, the potential for corporate culture clash very real, and the technology questions daunting. The need for huge scale to maximize profits and the limited time frame available to gather these assets put a premium on getting to market quickly with the right strategy and execution.

Nevertheless, the separate-accounts business offers potentially huge rewards. The land rush is on - with little certainty as to when growth will slow its blistering pace. Financial institutions should move quickly to evaluate this opportunity, establish a strategy and execute the game plan with speed.

About the authors
Kevin Freeman, Erik Davidson And Steve Schwarzbach

Steve Schwarzbach is a partner at Accenture, which provides advisory and integration services for separate accounts. Erik Davidson and Kevin Freeman (pictured) are co-founders of Separate Account Solutions. Separate Account Solutions provides an outsourcing platform for such clients as Royal Bank of Canada's Global Private Banking Group.