EXECUTIVE SUMMARY

SEPARATELY MANAGED ACCOUNTS ARE PRIVATE portfolios of stocks and bonds guided by professional money managers, who make decisions according to specific investment objectives. SMAs ARE APPROPRIATE FOR CLIENTS WITH significant assets who may have special tax considerations, such as capital gain/loss management and coordination with existing holdings. SMAs OFFER A HIGH DEGREEOF CONTROL. Investors own the stocks and bonds in the underlying portfolio, as opposed to shares or units of a commingled investment product, such as a mutual fund. ONE OF THE MOST APPEALING ASPECTS OF SMAs is that they can be tailored to the investor, which can enhance overall net investment return and satisfaction. TRANSPARENCY IS ANOTHER MAJOR ADVANTAGE of SMAs. Investors at all times know what investments they own and see the costs associated with managing their accounts. BEFORE OFFERING SMAs TO CLIENTS, CPAs need to be aware that doing so will invoke new responsibilities and potential pitfalls. Traditional referral sources may perceive you as a competitor; clients may need more personal attention and even think the new service presents a conflict of interest.

LEN REINHART is the president of Lockwood, a service of Pershing LLC, and founder of Lockwood Advisors, a subsidiary of The Bank of New York Co. His e-mail address is lreinhart@lkwd.com.

n today’s fast-paced and rapidly changing professional services arena, it’s becoming increasingly common for CPAs to broaden their offerings beyond traditional tax and accounting services into investment advice. One way to do this is with separately managed accounts (SMAs). SMAs are a good fit for CPAs for CPAs for two primary reasons: CPAs already are familiar with their clients’ assets and personal financial situations, and they have the expertise to provide the “high touch” financial guidance that more sophisticated investors expect. This article will explain SMAs in more detail and help you figure out which clients may be good candidates for managed money.

SMAs are private portfolios of stocks and bonds guided by a professional money manager who makes decisions according to a specific investment objective. Unlike a mutual fund, in which assets are pooled, the investor owns the underlying securities individually.

The benefits of SMAs have made them incredibly popular with the affluent, a group that is growing rapidly. The percentage of U.S. investors with more than $1 million in financial assets increased by 14% last year, according to a recent Merrill Lynch/Capgemini report. Furthermore, because advances in SMA “back office” technology have made it possible for management companies to efficiently handle a larger number of accounts, many money managers have dramatically lowered account minimums, making SMAs an option for more than just the wealthiest investors.

SMAs can directly affect a CPA firm’s bottom line as a supplement to the fee-based income stream. CPAs who charge an hourly fee for tax and accounting services can add extra recurring income from selling an asset-based product such as an SMA. As the value of clients’ portfolios increase, so does the firm’s fee revenue, with little additional work. You earn your fee by determining the client’s investing needs, crafting an asset allocation plan, analyzing suitable investments and monitoring the portfolio. But with the range of investment choices available amid an already crowded marketplace, convincing your clients of the value you add as a financial adviser can be a challenge. (For cautions and concerns, see “Caveats to Selling Financial Services”). Most objections are easily overcome, however, once you explain the benefits of SMAs.

GETTING STARTED
For CPAs interested in offering SMAs, a “do-it-yourself” approach is not only impractical, it’s impossible if their firm does not have its own investment advisory arm. Without one, the CPA would have to assume total responsibility for selecting money managers, constructing portfolios, keeping up with industry trends and producing performance reports. A less time-consuming and more cost-effective option is to enlist a third-party managed account provider that performs these services for a portion of the total SMA fee. By outsourcing money manager due diligence, investment research, trading, custody and operational and marketing support, you free up more time to advise clients. You also gain the confidence of knowing that responsibility for day-to-day portfolio management is in the hands of experts. To choose a managed money provider, consider the following three factors: service, breadth of product offering, and flexibility/customization options. Keep in mind that switching platforms can be an administrative headache, so it’s important to choose a partner that provides a good fit for your practice at the outset.

THE BENEFITS OF SMAs
One of the major benefits of SMAs is that they offer a greater degree of control than many other investments. This is because SMA investors own the stocks and bonds in the underlying portfolio, as opposed to shares or units of a commingled investment product, such as a mutual fund. In addition, SMAs exhibit greater transparency than mutual funds—both in terms of their holdings and the fees being charged to manage the portfolio—and can provide tax efficiencies.

Other major advantages of SMAs are:

Customization. You can establish a tailored investment program for your client, selecting money managers with investment approaches that closely align with his or her objectives and risk tolerance.

Restrictions. Investors can specify any industries or companies in which they wish to avoid investing based on personal social concerns or to prevent overlap with existing holdings. If a client objects to owning stock in tobacco companies or nuclear arms manufacturers, for example, or already has broad holdings in a particular industry, the money manager can place a blanket restriction on the account. It also is possible to invest in socially conscious SMAs.

Enhanced tax management. Tax management primarily occurs at the money manager and adviser levels. A tax-aware money manager can maximize after-tax returns. Because the CPA knows the individual’s overall investment plan—including outside holdings—he or she can direct the money manager to minimize realized capital gains.

Transparency. At all times, you and your client know which securities are held in the portfolio and the management fees associated with those securities.

All-inclusive fees. Generally, one annual fee covers all costs, including your fee and that of the money manager, and all custodial and transaction charges in the portfolio.

Style purity. Money managers are generally judged by how closely they adhere to a consistent investment discipline and are carefully monitored to prevent “style drift.” This investment style purity allows you to build diversified portfolios for your clients with confidence.

Because SMAs are customizable, they offer CPAs an opportunity to establish trust with more sophisticated clients. Instead of researching investment ideas (a role delegated to a professional money manager) for a commission, you can spend more time formulating goals, monitoring investment performance and creating a comprehensive financial plan. SMAs also can help you attract and keep bigger clients since they offer the cachet that discriminating investors desire.

CPAs should be aware, however, that due to their high minimum investment requirements, SMAs may not adequately meet the diversification needs of the less affluent. Money managers typically set minimum investment thresholds of $100,000 per managed account. To build an SMA portfolio with exposure to multiple money managers could easily require investable assets of $500,000 or more—an amount beyond the range of many investors.

AN ALTERNATIVE TO MUTUAL FUNDS
Infrequent communication is a common complaint of mutual fund holders, who have to make do with mailed quarterly statements and even more dated releases of top holdings twice a year. SMAs, on the other hand, can provide performance and holdings as of the prior day’s market close. Material portfolio changes often are communicated immediately via the money manager’s Web site or through e-mail. SMA investors know every investment held in their portfolio at all times, as well as the reasons for ownership and the rationale for each security trade. This information benefits your business, since many investors can relate to the stories behind individual stocks they own and equate more information with greater trust.

Fees are another issue that matter to every investor because they directly reduce investment returns, which can affect success in reaching long-term goals. With mutual funds, the various commissions, account fees, miscellaneous charges and expense ratio make it almost impossible to determine the real cost of investing. SMA fees tend to be more transparent. They typically break down into four components: the money manager’s fee, the platform sponsor’s fee, the clearing and custody fees and the adviser’s fee. This amount is usually stated in basis points (since increments can be less than 1%) and billed quarterly. SMA fee deductions are usually clearly itemized on the investor’s statement.

Mutual fund fees are much more difficult to decipher since they are deducted daily from the net asset value and are not seen by investors. Mutual fund fees are disclosed within the prospectus, but in technical language, so the investor is required to calculate the amounts. Also, a mutual fund’s expense ratio remains constant, regardless of account size. On the other hand, SMAs benefit from economies of scale and typically offer fee discounts on each component for larger balances.

THE SMA INVESTOR
SMAs generally are most appropriate for those with significant assets who may have special tax considerations—such as capital gain/loss management—or require coordination with other existing holdings. (See also “The Demographics of Bond Management”)

Optimal SMA tax management involves coordination among all the players in the process, including the money manager, CPA and client. The money manager can make decisions that maximize the portfolio’s after-tax returns through tax loss harvesting (selling a security at a loss and then applying that loss against a future gain). Some managers use a total return strategy that does not place as high a premium on tax efficiency. Depending on a particular client’s needs, tax efficiency or total return potential, you can decide which philosophy is more appropriate.

PRACTICAL TIPS TO REMEMBER

A do-it-yourself approach in offering SMAs is usually impractical for CPAs. A less time-consuming and more cost-effective option is to enlist a third-party managed account provider to perform these services for a portion of the total SMA fee. When choosing a managed money provider, consider service, breadth of product offering and flexibility/customization options. Remember that switching platforms can be an administrative headache, so it’s important to choose a partner that provides a good fit for your practice at the outset. Teach your clients the importance of feeding you tax-related information on a regular basis. Make it clear that unless you have a complete sense of their total financial picture—including investments that you do not advise them on—you won’t be able to optimize their tax situations. Before charging commissions, be sure you meet all license and registration requirements. Since most insurance policies covering CPAs exclude services for which you receive a commission, get a separate policy to cover SMA services.

THE OPPORTUNITY FOR CPAs
Management options for a client’s portfolio are a compelling benefit of SMAs for CPAs. Because the underlying investments have a known cost basis and acquisition date, you can plan to minimize realized capital gains. Clients who are long-term investors may want to avoid short-term capital gains, which are taxed at higher rates. You can use your awareness of a client’s tax situation to take losses to offset gains in other investments. For example, in the case of an unexpected taxable event, such as the profitable sale of a highly appreciated asset within a closely held business, you might direct the money manager to generate an offsetting loss by selling a particular stock lot. Teach your clients the importance of feeding you tax-related information on a regular basis. Make it clear that unless you have a complete sense of their total financial picture—including any investments that you do not advise them on—you will not be able to optimize their tax situations for them.

Because SMAs are flexible, they’re easy to integrate with an investor’s other holdings. For instance, you can restrict individual stocks to prevent additional exposure, as in the case of a highly compensated executive whose net worth is tied to a certain company. Furthermore, the ability to limit certain holdings may be advantageous to corporate directors or other “insiders” who are prohibited from owning shares in the same company or industry they represent.

High-net-worth investors are interested in simplifying their financial lives and seek financial services professionals who are advice-oriented rather than merely purveyors of product. CPAs may need to start thinking of themselves as “wealth managers” who take a holistic approach, one in which the client’s investment goals—not investment performance—become the primary focus. The affluent also are increasingly viewing SMAs as a “control account” for all their holdings, including mutual funds, real estate investments, insurance products and limited partnerships. Knowledge of how these products complement the SMA holdings at the core will become critical. The affluent also will continue to seek advisers who offer a comprehensive array of services and products with added layers of professional management. SMAs put CPAs in an enviable position to fill this role.

Caveats to Selling Financial Services

By Bart H. Siegel

Before you accept a fee or commission for providing financial services, think about it carefully. Your relationship with your client will change dramatically. This new, expanded relationship may provide additional revenues and help solidify client loyalty; on the other hand it will invoke new professional responsibility and may also contain new potential pitfalls.

The AICPA Code of Professional Conduct (ET section 102) is clear: “In the performance of any professional service a member shall maintain objectivity and integrity, shall be free of conflicts of interest and shall not knowingly misrepresent facts or subordinate his judgment to others.” Whether the CPA’s conduct is inappropriate is predicated on a “reasonable person standard.”

CPAs who offer separately managed accounts (SMAs), customized bond portfolio services, mutual funds, insurance or other investment products and services will face new challenges. For one, their traditional referral sources may now perceive them as a competitor. For another, the personality of a client may match the CPA’s practice as it relates to their traditional tax and accounting preparation services, but it may not be compatible as it relates to financial services. Conflicts of interest that did not exist in their previous relationship may now require reexamination.

Investment advisory relationships also are generally far more complicated than those related to providing traditional accounting services, and investment clients tend to call their investment advisers more frequently than straightforward accounting-services clients do. If investment objectives are not met, it may threaten both their investment advisory and accounting relationship. In the worst case, a potential malpractice suit, lawyers will review all correspondence and reports from the CPA to determine if there was even an implication that specific results would be obtained. Misleading claims violate professional standards and state and federal law.

CPAs should not assume that engaging an “institutional-quality asset management company” to manage the account mitigates their liability. When you accept a fee or commission, you also accept a commensurate amount of fiduciary accountability and legal liability. Most policies covering CPAs specifically exclude claims arising from engagements for which the CPA received commissions for the sale of investment and/or insurance products.

To accept commissions on the sale of investments you must be licensed with the National Association of Securities Dealers; to operate as a fee-based investment adviser you must be registered with the Securities and Exchange Commission. There also may be additional state requirements that must be met prior to selling investments or charging for investment advice. Licensing for insurance is handled separately by each state.

According to the Center for Fiduciary Studies, lawsuits and arbitration cases regarding the breach of fiduciary duty are increasing at a compound rate of 22% per year. The AICPA and the Foundation for Fiduciary Studies have jointly developed a handbook—Prudent Investment Practices: A Handbook for Investment Fiduciaries—designed to promote prudent investment practices. The book focuses on critical investment practices including asset allocation, investor risk/return profiles, investment policies, expected returns, the selection of prudent investment managers, documenting due diligence, proper management of investment expenses, procedures for avoiding conflicts of interest and prohibited transactions.

You will find that selling investment services requires quite a bit of work and diligence. It’s up to you to determine if it’s worth the effort.

Bart H. Siegel, CPA, CFP, CFE, is an independent investment and tax specialist who provides litigation support, expert witness services and continuing education seminars. He can be reached at bart@growthportfolio.com or at www.growthportfolio.com.