SMA Step-Out Trading Trends in 2009Managers demand automation amid inefficiency
Following the inaugural FRC SMA
Step-Out Trading Survey in March 2008,
the investment management industry
has undergone an extraordinary period
of change characterized by unprec-
edented economic pressures and the
consolidation of unlikely century-old
Wall Street competitors. These changes
have re-emphasized urgent issues in the
investment advisory business in general
and specifically, trading and settle-
ment concerns and efficiencies for the
separately managed account industry.
As the distribution landscape of the
retail SMA business continues to
evolve, investment managers remain
focused on building and improving
the operational efficiency of their
SMA trading practices. To assist
managers in this effort, FRC was
commissioned by Citi’s Investment
Administrative Services to re-engage
the asset management community
and further assess their retail
SMA step-out trading practices.
In this white paper, we review the
motivations behind step-out trading
(a.k.a. trading-away) and settlement
processing, examine the results of
a proprietary survey of investment
managers regarding their perspec-
tive on step-out trading and settle-
ment practice, issues and concerns,
and forecast the future of step-out
trading amid the changing face of
the managed account business.
Motivations Underlying
the Desire to Step Out
The trend toward increased step-out
trading is clearly motivated by several
factors, including a renewed focus
on best execution, the expansion
of sophisticated investment strate-
gies desired within the separately
managed account chassis, and
the need to enhance growth in
the managed account industry.
Best Execution — Meeting internal best
execution requirements is especially
salient in today’s heightened regula-
tory environment. The SEC continues to
focus greater attention on the managed
account space while emphasizing
the importance of providing best
execution for all client accounts.
In March 2008, Andrew Donohue,
Director of the Division of Investment
Management at the SEC, directly
addressed the SMA industry by calling
upon managers to detail and justify
their best execution efforts to clients:
“Firms providing managed accounts
should be attuned to how they are
meeting their best execution obliga-
tions. If client trades will be placed
with the managed account’s sponsor,
the adviser should be comfortable
that this arrangement achieves
best execution and that the client is
informed of this arrangement and
why it achieves best execution.” —
Remarks before the IA Week and the
Investment Adviser Association’s
10th Annual IA Compliance Best
Practices Summit 2008
Investment Strategy Sophistication —
While SMA assets have tradition-
ally been sourced from large-cap
domestic equity strategies, sponsors
have been increasingly demanding a
broader palette of SMA offerings from
investment managers. As a result,
managers have stepped up to offer
an increasingly exotic mix of invest-
ment strategies that spans market
caps and geographical boundaries.
Along with this continued growth
has risen the need to source liquidity
from specialized brokers that either
provide specialized trading platforms
or specialize in specific security types.
SMA Growth — Prior to the credit crisis,
SMA assets had been growing at a
torrid pace — from 2002 to 2007, SMA
assets grew at a 21% compound annual
growth rate. The major contributors
to this growth going forward will come
from outside the traditional wirehouse
distribution channel. Increasingly,
growth of SMA assets is driven by
sophisticated SMA wealth platforms
housed within the bank, regional broker-
dealer and independent channels. As a
result, investment managers will likely
have less confidence in the operational
abilities of program sponsors other
than non-wirehouse broker-dealers to
meet their best execution standards.
Step-Out Survey Overview
To gain a more complete understand-
ing of the challenges associated with
step-out trades and to draw relevant
comparisons to last year’s survey, FRC
launched a web-based survey of retail
SMA investment managers during
the first two weeks of March 2009.
FRC received 23 responses to its
investment manager survey. Mid-sized
managers, those with 5,000 to 20,000
accounts, represented 43% of the
respondent population, while small
managers, those with less than 5,000
accounts, represented 43% of respon-
dent firms. Due to the precipitous drop
in equity markets and the resulting
drop in industry accounts, large SMA
managers, those with 20,000 or more
investor accounts, represented only
14% of the survey response group.
The investment managers in the
respondent population represented
a wide variety of investment styles.
When asked to identify their three
primary SMA styles, large-cap stock
represented the predominant equity
style (18 managers). Over half of the
sample reported managing mid-caps (12
managers) while over 40% of managers
ran SMAs in international ADR (10
managers) and all-cap (10 managers
strategies). At the specialty end of the
investment spectrum were convertibles
(one manager) and preferred stock
(one manager). Within the fixed-income
disciplines, treasuries and agencies
were the predominant bond styles
(three managers) while three managers
identified themselves as primarily
multistate municipal bond managers.
State of the SMA Industry
An unprecedented credit crisis coupled with a
consumer-led recession in the United States
precipitated a sharp sell-off in almost every
global equity market during the past 12 months.
Since March 2008, the DJIA and MSCI EAFE
have declined 40% and 51%, respectively. The
concentration of retail SMA accounts invested
in equities (72%) has had a significant effect
on industry assets. According to the Money
Management Institute, SMA assets fell to $712
billion in fourth quarter 2008, representing
a $330 billion decline from 2007 year-end
assets. While overall managed account assets
declined 29% year-over-year (2007 to 2008),
UMA assets grew 15% to end 2008 at $45
billion. As UMAs continue posting market share
gains, increasing the operational efficiency of
traditional separate account business lines will
serve as a competitive imperative for many
investment managers in the coming years.
Motivations Behind Manager
Step-Outs
Step-out trading continues to be very
pervasive among SMA investment
managers. Nearly 90% of SMA invest-
ment managers in the FRC survey
population responded that they conduct
step-out trades. Slightly more than
25% of respondents indicated they
“always” conduct step-out trades for
investment model changes. While a
quarter of surveyed managers stepped
out trades depending upon the sponsor,
a larger percentage (43%) indicated
that step-outs were dependent
upon the security type being traded.
These responses were nearly identi-
cal to those we received in 2008.
Managers indicating they never step
out trades were either satisfied with
their sponsor’s execution capabilities or
dissuaded by the costs or operational
inefficiencies associated with stepping
out trades. Those managers indicat-
ing that they never step out trades
generally managed fewer accounts and
had only a limited number of sponsors
through which they did business.
Sponsor and Custodian Relationships
We asked investment managers to provide us with details about the number of sponsor
and custodian relationships they possessed. The data reveal that while some managers
have clearly cast a wide net among sponsor firms, a number of managers target their
distribution efforts toward a select group of the SMA sponsor population.
Sponsor Relationships
Accounts ManagedAverage # of
SponsorsMaximum # of
SponsorsMinimum # of
Sponsors
20,000 – 40,000 24 37 16
10,000 – 20,000 18 25 10
5,000 – 10,000 19 30 3
2,000 – 5,000 13 21 5
Less than 2,000 8 12 4
Overall 16 37 3
On average, manager respondents did business with 16 sponsors to support their SMA business.
The Chartered Financial Analyst (CFA) Institute’s trade-management guidelines define best execution as “the trading process firms apply that seeks to maximize the value of a client’s portfolio within the client’s stated investment objectives and constraints.” While most investment managers have established their own internal best execution criteria, the measurement and quantification of meeting “best-ex” continues to be an inexact science.
When we asked managers to identify
more specific reasons for stepping out,
80% of survey respondents specifi-
cally identified “best execution/compli-
ance requirements” as the primary
reasons for trading away. Additionally,
65% of managers indicated that
step-out trading was spurred by the
desire to block their retail order flow
alongside their institutional flow.
Other motivating factors included the
desire to fulfill larger/faster executions
(45%), a general dissatisfaction with
sponsor execution capabilities (30%),
and a lack of adequate security
coverage at the sponsor (30%).
I primarily trade only Opening andMaintenance trades with Sponsors
given the small order sizes
Reasons for not trading away
My system does not accommodate
The operations process to support step-outs/trade-aways is too difficult and
time-consuming
For the securities we trade, Sponsorsperform capable executions
Sponsors charge a fee to processstep-outs
Most Sponsors won’t let me/don’t like it
0% 10% 20% 30% 40% 50% 60%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Reasons for trading away
Best execution/compliancerequirements
Other
Use a Super-Broker
Security Coverage
Dissatisfied with Sponsors’execution capabilities
Larger orders/fasterexecutions
Block orders with other flow
Trade-Away Broker Attributes
While the definition of “best execution”
is anything but uniform, managers
reaffirmed that step-out trading is an
essential component of maximizing
their trading efficiency. Over two-thirds
of investment managers relying
on third-party brokers to complete
trades cited “security specialization”
as the primary characteristic of their
trade-away broker. Additionally, 42%
of respondents noted that step-out
trades were often directed to brokers
that covered them institutionally as
a major customer. Finally, a smaller
percentage of managers cited auto-DR
capabilities and access to ECNs or
ALGOs as motivating factors.
When asked how step-out trade
orders were blocked, more than half
of investment managers indicated
that block orders were sent from
their managed account systems to
their institutional trading system
and executed together with other
institutional business. Roughly equal
Trade-Away Broker Attributes
80%70%60%50%40%30%20%10%0%
Other
Provide auto-DRcapabilities
Provide electronic market making
Have ECNs
Provide ALGOs
Cover me institutionally asa major customer
Specialized in certiansecurity types
Handling of Trade Away Orders
SMAs tradedseparately, but in
rotation with otherbusiness
20%
SMAs tradedindependently ofother business
24%
Other4%
SMA blocks mergedwith institutional
trades52%
camps of respondents indicated
SMAs were traded separately but in
rotation with other businesses (20%)
or SMAs were traded independently
of their other business lines (24%).
Security Types Traded Away
Step-out trades continue to be driven
by security type as managers seek to
place orders with third-party brokers
that either specialize by security
type or provide access to special-
ized liquidity pools not found at the
program sponsor’s trading desk.
Fixed-income securities remain the
most prevalent security type traded
away from SMA platform sponsors.
While the data was drawn from a
limited number of managers who
specialized in retail fixed-income
SMA offerings, they uniformly
indicated stepping out taxable/
high-grade and corporate securities.
Within equity styles, small-caps
(75%), all-caps (70%), and interna-
tional ADRs (80%) were noted
by a majority of respondents as
representing the most prevalent
security types to be traded away.
Interestingly, we found that step-out
trades are not relegated to specialty
and illiquid corners of the market.
A third of manager respondents
reported stepping out large-cap equity
trades from the program sponsor. In
2008, 44% of managers reported
stepping out large-cap equity trades.
International and global
ADR managers have
recently benefited from
the SEC’s relaxation of a
paper filing requirement
for foreign companies in
October 2008. The rule
change resulted in the
creation of roughly 700
new ADRs. According to
the Bank of New York
Mellon, there are now
more than 1,800 ADRs
trading in the U.S.
0% 20% 40% 60% 80% 100%
Trade-Aways by Security Type
FI — Corporates
Balanced
Large-Cap Equities
All-Cap Equities
Small-Cap Equites
International ADR
FI — Taxable High Grade
Costs of Stepping Out
Costs associated with step-out trades
often depend on the scale of the trading
relationship and any relationship/
enterprise pricing associated with the
selection of a third-party broker. While
most firms reported that the costs
of step-out trades are netted up into
the trade, nearly a third of managers
indicated that trading on their retail
managed accounts was free as part
of a broader institutional relationship.
Only a small fraction of managers
reported directly absorbing the costs of
stepping out. Those managers disclos-
ing specific trading costs generally
paid $0.01 and $0.03 per share.
Step-Out Trading Volume
Expectations
While account opening and mainte-
nance volume is typically traded with
the sponsor — 70% of managers step
out less than 10% of this volume —
given the relative size of the trades,
model change/across-the-board volume
is traded away much more frequently.
Nearly a quarter of managers traded
away more than 90% of their model
change volume. Overall, 52% of
Costs of Stepping Out
Trading free withrelationship
30% Commission passedto investor
15%
Manager absorbscommission
4%
Costs netted up52%
0% 5% 10% 15% 20% 25% 30%
<10%
10% – 30%
30% – 50%
50% – 75%
75% – 90%
>90%
Stepped-Out Model Change/Across-the-BoardOrder Volume
managers indicated that more than
half of their model change/across-
the-board volume was traded away.
The future volume of step-out trades
will trend higher according to many
managers.
When asked to provide their expecta-
tions for future step-out trading,
every manager indicated that SMA
step-out trading would either remain
at the current level or increase.
Desire for Solutions
The overwhelming desire for automa-
tion is largely associated with the
manual processes still required
to process and settle trades with
sponsor firms. Nine in ten managers
we surveyed indicated a desire for
automated step-out trading and alloca-
tion processing to sponsors. More than
half of managers also desired more
automation with regard to allocation
and settlement services with custodians.
Over two-thirds of investment
managers indicated that they often
assist the trade-away broker and
custodian during the step-out settle-
ment process with the Sponsor. The
majority of investment managers
indicated that their assistance was
necessitated by the Sponsor’s lack
of understanding of the intricacies
associated with managed accounts.
The growing demand for more efficient
SMA trade processing is evident. As
more solutions are implemented at the
asset manager level, automation will
clearly benefit the industry by reducing
risks and costs, promoting a wider range
of SMA investment styles, and
increasing manager participation in
the SMA industry.
Model Change/Across-the-Board Order VolumeTrade-Away Expectations
Increase45%
Stay the same55%
Account Opening and Account MaintenanceTrade-Away Order Volume Expectations
Increase36%
Stay the Same64%
Reduce Risk/Costs • — There is a
clear desire among managers to
streamline the step-out process
in order to avoid trade booking
errors and increase the efficiency
of step-out trades. In fact, almost
half of the managers we surveyed
still reported using manual methods
(phone, fax, e-mail) to generate
and communicate step-outs.
Ultimately, increased automation
would allow managers to more
effectively account for trades
and improve the efficiency of the
shadow-accounting process.
Promote More Investment Styles • —
The roster of investment styles
managed in the SMA vehicle contin-
ues to expand beyond traditional
U.S. large-capitalization products.
As this growth occurs, demand for
access to specialized securities
brokers will increase along with
the need to step out more trades.
Encourage Manager Participation • —
While the SMA industry has
undergone impressive growth, the
inherent operational complexi-
ties of managing retail separate
accounts have served as a barrier
to entry for many institutional
investment managers. Automation
and broader messaging standards
will prompt more investment
managers to enter the retail SMA
Step-Out Manager ConcernsOutsourcer
handlesthe problem
12%
Trade-awaybroker doesn’t
understandmanagedaccounts
57%
I am unaware ofsettlement process
problems; itseems to work
without my intervention
31%
Sponsor/Custodian for the block trade to the Broker
Trade awaybroker and
custiodian, but weare not involved
20%Trade awaybroker and
custiodian, butwe often assist
70%
My firm10%
Trade-Away Order Generation: Percentage ofManagers Employing Manual Methods
Fax
Phone
0% 10% 20% 30% 40% 50%
business, expand their participa-
tion on multiple sponsor platforms,
and ultimately reduce their
back-office overhead expenses.
Future Trends Impacting SMA
Step-Outs
The operational hurdles associ-
ated with step-out trading continue
to affect SMA growth. However,
several trends will have an important
influence on the future of SMA trading,
including the growing influence of
model management, the launch of
no-fee mutual funds, the creation
of non-ADR strategies, and the
growing influence of regulation.
No-Fee Mutual Funds • — No-fee
funds, which are specialized
no-fee 1940 Act funds that sit
along individual securities within
a managed account, help add
additional exposure to small- and
mid-cap stock ranges within interna-
tional equity mandates. Additionally,
no-fee funds have helped drive
down the investment minimums
for fixed-income strategies. To
date, approximately 20 invest-
ment managers have launched
these products in the SMA space.
Model Management/UMAs • —
The industry continues to march
slowly but surely toward the
model managed or “paper portfo-
lio” environment whereby SMA
managers cede control of trading
to the SMA sponsor. While Merrill
Lynch is currently running its
traditional and model-driven
platforms side by side, the industry’s
biggest SMA sponsor is expected to
transition its entire book of business
over to the model environment in
the coming quarters. Provided the
other wirehouses follow suit, expect
the overall volume of step-out
trades to decrease in time. As of
year-end 2008, UMA assets stood
at $39.6 billion, according to the
Money Management Institute.
Non-ADR International Strategy • —
As more investment managers
offer internationally oriented SMAs
that invest in securities across
the globe rather than U.S.-traded
ADRs, trading dynamics of these
SMAs will change profoundly.
MFS and Merrill Lynch combined
efforts in July 2007 to launch one
of the industry’s first non-ADR
international strategies on Merrill’s
newly launched UMA/Unified
Diversified Portfolios platform.
Best Execution/Compliance •
Requirements — As previously
mentioned, best execution
continues to be a focus of regula-
tors. While some sponsors have
instituted the practice of requir-
ing clients to sign “direction
letters” that waive best-execution
requirements, most sponsors
remain open to the practice of
stepping out trades. Seven of ten
program sponsors in FRC’s 2008
SMA Sponsor Survey population
indicated that while they preferred
that trading volume pass through
their desks, it’s left to the invest-
ment manager’s discretion if and
when to conduct a step-out trade.
In recognition of the growing demand for unified product neutral wealth solutions, Citi recently announced the launch of its OpenWealthSM platform. The solution represents the first Unified Managed Household (UMH) servicing platform to provide automated household portfolio and tax optimization for investors serviced through distribu-tors and sponsors of wealth management. TIAA-CREF recently chose OpenWealth as the operating platform for its fee-based wealth management solution.
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