Understand Separately Managed Accounts

Stung by poor performance and scandals, somemutual fund investors are turning to an investmentvehicle already popular among thenation's wealthiest: separately managed accounts.But these types of accounts are not right formany investors, so consider their pros and cons carefullybefore deciding whether to abandon mutual funds.

Separate Account Advantages

A separately managed account is a customizedinvestment account comprised of individual securitiesmanaged for a single investor by a professional moneymanager or a team of managers that also handles otherindividual accounts. Each account typically buys andsells individual securities on your behalf, focusing ona particular investment style, such as large or smallcap stocks, value or growth stocks, and certain typesof bonds. To stay diversified, many investors havemultiple separate accounts. Investors can open separateaccounts directly with money management firmsor through a financial advisor who selects the separateaccount managers.

To open a separate account, you'll typically haveto invest at least $100,000 to $250,000—vs $1000to $5000 for mutual funds. Some minimums start at$1 million or higher, though a few are as low as$25,000 to $50,000.

Even if you have just enough money to qualify forone of the lower minimums, there are the immediateissues of asset allocation and diversification. A specificseparate account generally does not consider your overallportfolio, such as your retirement account at work orother investments you have. The asset allocation remainsup to you and a financial advisor, if you use one.

One of the major attractions of separate accountsis their customization. An investor sitting on largeamounts of company or industry stock might directthe money manager to steer clear of the same kind ofstock—something you can't direct a mutual fundmanager to do. This can help diversify a portfolio.

Downsides and Criticism

Critics contend that many separate accounts, especiallymodest-size accounts, offer little real customization.The account manager is apt to simply invest thefunds using a model designed for similar clients.Critics also point out that direct contact with theaccount manager is often not as easy as someinvestors are led to believe.

Some investors are especially attracted to separateaccounts these days because they are more transparentthan mutual funds. You know exactly what securitiesare in your account and you have records of alltrades. No market timers or after-hours traders aregoing to skim profits from you as they have withmutual fund investors.

The downside to this transparency is often a flurry ofpaperwork and the easy habit of following your investmentsdaily or weekly—a habit that can lead to too muchshort-term investing instead of taking a longer view,which is typically recommended by financial planners.

Separate accounts also may appeal to investorsseeking greater tax efficiency. This is because they candirect a manager to buy or sell specific securities tooffset other losses or gains, thus reducing taxes. Butthe ability to achieve this tax benefit will depend inpart on how customized your account really is. Criticsargue that you can do just as well with either indexmutual funds or funds that specialize in keeping yourtax liabilities low.

Two other controversial areas are performancetracking and fees. To date, there has been no centralizedway to obtain performance data on separateaccounts, as opposed to very public mutual funds.Also, account fees can easily run from 1.5% to over3%—higher than most mutual fund fees. Proponentsmaintain that investors can find comparable or evenless expensive accounts, and that separate accountfees include transaction costs, which mutual fundexpense ratios do not include.

This article has been produced by the Financial Planning Association(www.fpanet.org), the membership organization for the financialplanning community.