As the separate account industry continues to grow, an array of companies has cropped up offering optimization tools and software to help advisors manage clients’ portfolios. But it’s a good idea for independent advisors using these tools to stick with the providers, and forego attempting to wield them alone. “Some advisors have said, ‘We think we can buy a tool and do it ourselves,’” says David Stein, managing director of Parametric Portfolio Associates in Seattle, an investment firm specializing in index-based portfolio optimization with an active tax management strategy. “Very often [advisors] come back with their tails between their legs and say, ‘Okay, you guys do it.’ Unless [advisors] really understand the tools, they should be using a subadvisor because the tools are hard to use and interpret, and can be misused.”
Optimization software is an essential instrument that advisors and other money managers dabbling in separate accounts need to use to provide more and more customized money management services across a growing base of accounts, says Stephen DeAngelis, president of ADVISORport. “Without [portfolio optimization] software, the only service that the money managers can effectively deliver is to match all clients up against some model,” he says. Without the software, he says, advisors will have a hard time delivering a customized account that’s tax sensitive.
DeAngelis believes that if an advisor is an asset gatherer, it’s probably best for him to continue to use optimization tools in conjunction with a third-party organization. If, on the other hand, an advisor is a more sophisticated and technically proficient money manager, with the proper training, he could probably use the tools effectively.
Dennis Clark, CEO of Advisor Partners in Denver—whose firm specializes in low-cost separate account programs based on index products—says advisors that solely use Web-based optimization tools to solve their investment management ills aren’t doing themselves any favors. “Look at where all of the fees accrue: The majority go to the relationship manager,” he says. “So if I were an advisor, especially in today’s environment, I would focus on that part of the value chain, or would look to outsource the investment management, of which portfolio optimization is one critical component, to an extremely competitively priced selection of alternatives.”
So what types of optimization tools are out there? And who are the providers? Popular software companies that are being used by money management firms to augment their investment process that cropped up during the reporting for this story include Boston-based Northfield Information Services; Barra of Berkeley, California; and Seattle-based Tamarac. “Advisors will use the software to perform the asset management function themselves as opposed to outsourcing the responsibility,” Clark says. “These software companies,” DeAngelis says, “provide investment organizations with tools to run optimization algorithms to match client accounts against model portfolios and, in some cases, to take taxes into account.”
Mark Balasa, a planner with Balasa, Dinverno, Foltz & Hoffman, LLC in suburban Chicago, says his firm uses both Parametric and Tamarac. With Parametric, “you give them the assets and they do all the heavy lifting,” he says. Within the last year, his firm has started using Tamarac, and has found that the software the firm provides is helping to lower his advisory firm’s expenses. With Tamarac, “we can drive down the internal cost because now we are not paying someone outside of us to do the optimization, the tax trading, and swapping,” he says. Another advantage is the ability to customize the Tamarac software to suit clients’ specific needs. “If we’ve got a client with a low-basis stock position, this is an awesome tool,” Balasa says. “Someone that has specific issues outside of what’s in this account, somewhere else in their financial life, we can customize [the software] for it.”
Balasa’s firm is also considering using optimization services offered by State Street. State Street’s services are “just like Parametric’s—but State Street has a $5 million account minimum,” he says.
Balasa says he runs a pretty sophisticated firm, and believes most of the garden variety one- or two-man advisory firms lack the internal manpower to try and fly solo with optimization tools. “It does take a certain degree of internal firm resources and people who are competent in financial markets, trading, and portfolio index construction [to make these tools perform effectively],” he says.
When considering optimization tools and software, Balasa says, it’s important to examine the cost to the client and the trading cost. Tamarac charges the average client 45 basis points, but the fee decreases as the size of the account increases, he says. “When you have a separate account, these strategies have a lot of trading because you’re constantly looking for tax benefits,” he says. “So you either have to have a very low per-transaction fee built into this model or asset-based pricing, which is the approach that we’ve taken.”
ADVISORport’s DeAngelis has relationships with both Parametric and Tamarac. ADVISORport is using Tamarac’s software to take a different approach to managing its own Multiple Discipline Accounts (MDA), also referred to as multiple style accounts (MSA). “Most of the MDA offerings out there are run by a money manager that mixes together some of their own investment products,” DeAngelis says. “We’ve worked with some of our third-party money managers, where they provide us with their investment models and we become the discretionary manager. So we mix and match the models to create different MDA allocations using unaffiliated third-party managers, and for clients looking for active tax management, we do this tax-managed optimization overlay on top of that, and that’s where we are using the Tamarac software.” In today’s market, where returns are likely to be modest, he says, “you need to provide that tax management optimization; that’s a key benefit.”
Jim Reilly, senior analyst with Regent Atlantic Capital in Chatham, New Jersey, says his firm uses Northfield Information Services’ software product, called Open Optimizer, to formulate tax-efficient index portfolios. “Open Optimizer allows you to customize all sorts of parameters, from amortizing your trading costs to varying how much systematic and unsystematic risk will impact on your optimization; and there are variables that you can perform,” he says. The software also allows the advisor to “tilt your portfolio in pretty much any quantitative manner that you can think of—towards value or growth—while still optimizing towards a benchmark index. So if you want a growth-oriented portfolio that has a growth bias but it doesn’t get too far away from the S&P 500, you can do that.”
Regent Atlantic has been “very successful,” Reilly says, in using Open Optimizer to formulate tax-efficient portfolios. “If I own an S&P 500 index fund, just like any other mutual fund or exchange-traded fund, they have to pass out the gains at the end of the year; they can’t pass out the losses—those stay with the fund,” he says. “However, what we are able to do with Northfield’s [software] is generate a portfolio of 40 to 50 stocks that will track the S&P 500 pretax within 2% or 3%, and we can harvest the tax losses along the way. So that harvesting of the tax losses is a parameter in Northfield’s [software] that we can manipulate to make part of the optimization.”
Clark of Advisor Partners says advisors are increasingly becoming partial to a separate account strategy from Advisor Partners called “The Halfway House.” Under that strategy, Advisor Partners becomes an advisor’s sole separate account manager. “If you, as an advisor, believe that a good portion of the U.S. equity market is efficient—that after fees and taxes it’s hard to beat an index approach—then you can assign that equity allocation to a single separate account manager [in this case Advisor Partners] that assembles a portfolio of individual securities that is benchmarked to a particular index,” Clark says. “And then you would continue to use for the other allocations—whether it’s fixed income, international, or alternative investments—those institutional mutual funds that have been made available. I call [this approach] just a smart way to provide high-net-worth clients with a separate account solution with all the heavy lifting you want in the separate account—customization, tax management, and complementing it with mutual funds, or in the alternative investments, a fund of funds format.”
Norm Boone, president of Boone Financial Advisors in San Francisco, says he likes Advisor Partners’ approach to separate account management because it’s based on an index. “They are attempting to do what I refer to as a ‘sampled index.’ In effect, if they are doing the S&P 500, they might only have 80 of those 500 stocks—it’s a sample of each of the major industries,” he says. “Because you don’t have to own all 500 stocks, it allows for the possibility of smaller accounts to be reflective of the index.”
Optimization tools are an important component to an advisor’s separate account strategy. Advisors will be well served by relying on expert help to get the most out of these tools.
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