Custom-Built

With demand for personalized advice growing, financial-services firms are overhauling their technology to mass-produce separately managed accounts (SMAs) with a high degree of customization. But mass customization of individual accounts requires a highly automated, efficient process - analogous to a manufacturing plant in the automobile industry. Just as cars roll off an assembly line with standard features such as AM/FM radios and air bags, as well as custom extras such as CD players and moonroofs, financial-services providers must be able to churn out investment portfolios that meet the unique needs of each client.

Individual clients have different circumstances and expectations - unique asset-allocation models, expected rates of return, risk tolerance and tax situations, as well as legacy holdings in company stocks and social restrictions. Whereas some financial-services providers sell standardized model portfolios as "customized" offerings, "We're customizing each portfolio for each client," explains Todd Smurl, managing director of portfolio management at Compass Bank.

In April, the Birmingham, Ala.-based bank - which ranks among the top 50 banks in the country, with $4.5 billion in discretionary assets - expects to go into full production with Smartleaf's overlay portfolio management platform. Compass will utilize the Smartleaf technology to build customized portfolios that are capable of combining equities, mutual funds, exchange-traded funds and fixed-income instruments within one account, known as a unified managed account, or UMA.

With the help of Denver-based consultant Prima Capital, Compass selected eight equity managers to feed their model portfolios into the Smartleaf system. Rather than hire external managers for fixed income, Compass plans to run the high-grade fixed-income instruments internally. About a dozen client-facing Compass investment professionals who service the bank's high-net-worth clients will interface with the system. "We're very excited about the ability to customize and the workflow automation that overlay portfolio management brings to the table," says Smurl of the Smartleaf technology, which allows the bank to leapfrog the process of establishing a traditional SMA structure.

Under the traditional SMA operating model, asset managers have to hire portfolio managers to oversee hundreds of accounts and establish a back office to handle account administration. They also need a staff to buy and sell orders and marketers to entice brokers to sell their services. The new overlay management platforms eliminate the need for an entire layer of infrastructure because the sponsor is buying the managers' models and taking over all the managers' roles: portfolio construction, trading and reconciliation in the back office. In exchange, the sponsor is receiving a discount on the money managers' fee.

The Father of Portfolio Manufacturing

Last winter, James Hollis, managing director at Cutter Associates, coined the term "portfolio manufacturing" to describe the automation of the investment-management process. Hollis picked up the analogy after he read "The Machine That Changed the World," a book written by a couple of M.I.T. professors that revolutionized the car industry. Industry sources say portfolio manufacturing is part of an ongoing revolution of the separately managed account business that is being driven by technology aimed at streamlining operations and cutting costs, much as the assembly line did for auto manufacturing.

Brokers, trust banks, private banks, high-net-worth managers and mutual funds will need to reengineer their business processes, technology and cost structures in order to compete in the new portfolio "manufacturing" environment, notes Hollis. Trust officers, for example, currently look at information and make unique investment decisions for every client. "They're making all these different portfolios on their own parameters without a lot of consistency - [there's] no quality control," asserts Hollis.

But portfolio manufacturing technology still is a maturing market. In 2004, Hollis conducted a survey of 100 technology providers and found that only 20 offered solutions that qualified as manufacturing platforms. Among the portfolio manufacturing technology players he identified are Life Harbor (acquired by Vestmark), Smartleaf, Tamarac, Upstream Technologies, Financial Engines and Folio FN. Another potential contender is Odyssey Asset Management, which mainly operated in Europe for private banks but recently opened a New York office.

Portfolio manufacturing systems are able to customize investment portfolios against model portfolios - standard equity and bond portfolios as well as ETFs and mutual funds - that track a benchmark. They factor in raw data such as rankings of securities, client risk, expected return goals and tax-lot accounting - all of which goes into a mathematical software program called an optimizer.

While optimization has been around since the '60s and was popularized in the '80s by Barra's risk management software, optimizers now can scale to handle a high volume of retail accounts. "The math is the same," says Mark Hoffman, chief executive officer of Upstream Technologies. "But with modern technology, you now can use that optimization function on thousands and thousands of accounts," he says. One Upstream client, American Century, loads its expected return rankings for the universe of securities, along with its current portfolio and its model or the benchmark it's supposed to track into Upstream's optimizer. Then Upstream generates the buy and sell lists - "the trade orders to get you there," explains Hoffman.

"Upstream is kind of like the Mapquest for users; you tell me where you are and where you want to go, and we'll produce the directions on how to get there," continues Hoffman. Upstream IMS, a comprehensive investment management system, also factors in liquidity constraints and transaction costs as part of the equation and integrates with Lava Trading's direct-access trading platform, so each retail account can have its own automated trading strategy.

Many third-party portfolio manufacturing tools allow portfolio managers to implement their own trading models - their best buy and sell ideas - in the context of client constraints, according to Alan Robertson, managing director, wealth advisory group, Northern Trust Company.

"The technology has the potential for changing the economics for portfolio management," says Bob Hollinger, a partner in Boston-based consultant Barrington Partners. Not only will portfolio manufacturing help portfolio managers develop their models, but it also can monitor the performance of the portfolios on a day-to-day basis, according to Hollinger. "It can identify wherever there is a drift or deviation from the portfolio objectives and identify specific actions to be taken to bring the portfolio back in line with its model," he says.

Some offerings even track the reasoning behind trading decisions, according to Jeff Augustine, a consultant to Upstream Technologies and a former senior vice president at Putnam Investments who ran portfolio construction for an SMA program. If the system rejects a trade for a particular account - because there's a restriction against owning IBM, for example - the best of the portfolio manufacturing systems will store the reason so that there's an audit trail, he relates.

Who's Driving?

But the question is: Which financial-services entity is operating the portfolio manufacturing platform? "If you go back six or seven years, the idea of using technology to do portfolio construction was a novel idea," says Christopher Jones, executive vice president, investment management, Financial Engines. In the past, the person using the tool was a portfolio manager or a consultant - highly paid experts who understood the limitations of market data and knew how to deal with unique issues, such as restrictions and unrealized gains that come up during optimization, Jones continues.

Now, the tools are falling into the hands of bank trust officers, financial advisers at broker-dealers and relationship managers at private client banks. "What we're seeing is a desire to serve the needs of a large number of individuals on a personalized basis because that's what the market is demanding," says Jones. "To do that you need technology that is an order of magnitude more sophisticated than what is on your broker's desktop."

Portfolio manufacturing platforms blur the line between the distributors of separately managed accounts (i.e., banks and brokers that own the relationships with the clients) and the asset managers (i.e., mutual funds and money managers) that design the model portfolios and implement the manufacturing process. With Internet-based platforms that can be engineered to scale across thousands of retail accounts, SMA programs can bypass the inefficiencies of legacy platforms and be set up relatively quickly.

In the traditional SMA business, money managers that participate in the major programs - run by Smith Barney, Merrill Lynch, Morgan Stanley and UBS - must interface with each sponsor. "It is an operational nightmare for an asset manager to be linked up to multiple distribution points where there is no standardization among these sponsors," says Chandresh Iyre, managing director of Citigroup Global Transaction Services (GTS) and head of the product management team for North America fund service. Citigroup GTS plans to introduce a platform during the first quarter that can apply model portfolios across hundreds of thousands of accounts as an outsourced service. Citigroup will offer a single front end that insulates the portfolio managers from the unique requirements of the sponsors, he says. It also will enable portfolio managers to perform "what if" analysis to validate ideas across the accounts they manage, adds Iyre.

Outsourcing the Manufacturing Process

To avoid the complexity of receiving the managers' model portfolios and communicating back and forth between the sponsors and multiple asset managers over new account set-ups, and routing of trades and reconciliations, some financial-services providers are hiring overlay portfolio managers.

About six months ago, RBC Dain Rauscher, the Dallas-based broker-dealer, hired Placemark Investments, an overlay portfolio manager. Dain's UMA program combines multiple separate account managers into one account and also can incorporate stocks and bonds with mutual funds and ETFs in a single account. "Prior to this, you had to open up an individual account for every money manager you hired," says Erik Preus, director of investment consulting services at RBC Dain Rauscher. In addition, Placemark has a proprietary optimization tool that will do active tax management at the client level to minimize short-term capital gains, according to Preus.

Clients would work with one of Dain's consultants to put together an asset allocation with which they're comfortable and then select the managers - the program spans 21 managers and 31 investment disciplines. "The money managers give Placemark their model portfolio and Placemark implements that," relates Preus.

On Placemark's end, different managers are sending updates to their models that trigger the manufacturing process. "It's completely automating the receipt, comparison and validation of the model portfolios into our investment process," says Randy Bullard, president of Placemark, which runs a total of 85 investment managers and more than 125 investment styles in its Dallas operations center. Then, every morning, the overlay firm pulls information on Dain's clients - individual holdings, tax lots and reconciled positions. "This information comes into a gigantic investment problem," explains Bullard. Given the managers' current models, the client's holdings and the client's unique constraints, the portfolio manufacturing engine comes up with a set of trades to implement the model portfolio.

Then Placemark aggregates all the buys and sells for every client and rolls them up into block trades that it enters into Dain's trading system, CheckFree Investments' Security APL. But it also includes the allocation file, which, for example, tells the system to allocate 40,000 shares to a particular client's account. "Placemark implements all the trades - they help us do automatic rebalancing, which was very difficult when you had multiple accounts," says Preus. Automatic rebalancing - investing new cash that comes into the account or instructing three managers to sell stocks and a fourth to buy stocks when a model changes - doesn't get done in the traditional SMA programs, says Bullard.

Running the Manufacturing Plant In-House

By contrast, Compass Bank is running the Smartleaf portfolio manufacturing system in-house. "Unlike traditional architecture platforms, we're not shipping money out to the money managers. Research is at the core of a money manager's work, and we're literally buying the managers' intellectual property in the form of model portfolios," says Compass' Smurl. "Through the use of overlay technology, we're able to implement those models in a way that's both customized and tax aware. It's simply a better product for the client."

As a result, Smurl says the bank is going to be able to mass produce customized portfolios and automate the workflow. "The [overlay] product eliminates redundant costs in the supply chain and allows us to both build our separate account business and maintain our profit margins," he asserts. "Because we're able to cut costs out of the supply chain compared to the traditional architecture, we're very competitive in the marketplace, particularly since we don't charge more for optimization."

Despite the efficiencies offered by portfolio manufacturing systems, which have been around for about six years, the industry has been slow to adopt them "because there's so much money in the legacy platforms," claims Smurl.

But this is changing, according to Barrington's Hollinger, who says the number of financial firms looking for a solution is growing. "As the demand for separate accounts grows, the demand for operational solutions is going to grow," he says. "That growth is beginning to take a big move upward."

Cutter Associates' Hollis agrees. "Everybody wants to be a wealth manager," he says. "Manufacturing is the way to go there. It's a more efficient and better product if it's all automated."

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Retirement Map: 401(k) Managed Accounts

Last fall, mutual fund giant Vanguard began offering a managed-account program for 401(k) participants in conjunction with Financial Engines. The product offers investors a customized portfolio of mutual funds.

"Financial Engines is really doing a customized portfolio. It's not like a lot of advice tools that will put people in one of six cookie-cutter portfolios," says Bert Dalby, principal with The Vanguard Group. "This is using technology [to offer] a number of unique portfolios - it's definitely unique to individuals and how they respond to the questions around retirement age and how they're allocated. That's really the power of the technology," he continues.

The 401(k) service is targeted at "avoiders" - participants who have no desire to manage their portfolios and prefer to turn them over to someone else.

Financial Engines has built a sophisticated optimization program that can cover anywhere from five mutual funds in an individual's 401(k) program up to the 12,000 mutual funds in the universe, says Christopher Jones, executive vice president of investment management at Financial Engines. "It takes into account risk profiles, existing holdings, tax considerations, spousal assets, outside assets, positions in concentrated equities, and picks a mix of funds," says Jones, who notes that the technology is extensible to both mutual funds and individual securities.

Though the managed-account program is automated, Vanguard does charge an additional fee for the service. The fee starts at 40 basis points and declines to 10 basis points on balances of $500,000, relates Vanguard's Dalby.

"Long-term, this is the kind of technology that in five or 10 years will almost certainly displace humans putting together portfolios," predicts Financial Engines' Jones. "It's cheaper, it results in much higher quality recommendations and you can amortize the investments across lots of people." Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio