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

E-mail

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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