Volume 5, No. 6

The question that persists during this particularlydifficult period in the capital markets is whether

the role and purpose of a brokerage firm is simply toexecute securities trades or is there an associatedresponsibility to assist and/or empower the financialadvisor to add tangible, quantifiable value through theexercise of their professional investment and adminis-trative counsel. These two vastly different managementphilosophies in the financial services industry explainwhy top management at some firms seem to discountany need for change or innovation while other quartersof the industry deem it to be essential. The old schoolwould suggest we are in the trade execution business,while the new school of thought would suggest we arein the business to add value.Ultimately, the financial serv-ices consumer will resolvewhich philosophy best servestheir interests, and in recentmonths, the consumer has sentthe industry a very clearmessage.

In today's terribly difficultinvestment environment theonly constituency of financialadvisors who continues togrow their business at adouble-digit clip are the 12%of financial advisors who areaddressing and managing abroad range of investment andadministrative values throughthe engagement of theirprofessional investment andadministrative counsel for anon-going consulting fee. Thisis while 65% of financialadvisors who are engaged incommission sales have experienced a 52% decline inearnings over the past year. The financial servicesconsumer is telling us they want value to be added, sothere is little question of where the marketplace isheaded. Thus, if one is interested in the consumer, thechallenge our industry faces is how do we go beyond asmall number of early adopters who are adept at addingvalue to empowering all financial advisors to addvalue. This is no small challenge as a different culture,structure and technology is required in order to addvalue. The skill, passion and motivation of early

Overlay Management: The Whole Product Solution?Stephen C. Winks

adopters simply does not extrapolate to an earlymajority of all financial advisors that need to quicklylearn how to add value. Even if all financial advisorswere to be provided access to the processes and tech-nology necessary to add value, it does not mean thatvalue would necessarily be added, as skill is required.Overlay management, an outgrowth of the multi-discipline account (MDA), may well be the answer. Byextension, overlay management may be the vehiclethat puts the advisor and the industry back on track forpositive earnings and revenue growth.

Overlay management is a third level of assetmanagement, complementing that of money managersand financial advisors, which addresses and manages

portfolio detail at the clientlevel, e.g., tax efficiency, riskand return, which are notpossible to manage at themoney manager level and arebeyond the technologicalexpertise of most financialadvisors. This is accomplishedby overlay managers, likeParametric and Placemark,taking all the buy-and-sellrecommendations of an unlim-ited number of managedaccount managers in eachclient account and managingthe aggregated recommenda-tions to reduce undue concen-tration in a single holding, tooptimize trading to facilitatetax efficiency and reduce port-folio turnover and trading costusing expert systems, and tooptimize portfolio perform-ance using proprietary

methodology, which can add 35-100 basis points inoverall portfolio performance. Overlay managers likeParametric and Placemark empower financial advisorsto add value in ways which would not otherwise bepossible. Through expert systems, the overlay managerempowers the financial advisor to articulate anddeliver the benefits of tax efficiency that go far beyondthe advisor's personal skill and knowledge. The advisordoesn't have to understand trusts or sophisticated taxplanning strategies, they just have to do what they dobest: understand their clients' needs and deliver best-

The key tounbundling asset

management pricing,to managing a

higher level ofclient specific

portfolio detail, todriving down

administrative cost,to taking advice intothe mass market, to

enhancingperformance by

30−100 basis points

The Voice of the Investment Management Consultant

Senior Consultant

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in-class solutions leveraging through theoverlay manager's expertise. Most importantly,overlay management resolves many of thetechnological and innovation challenges thefinancial services industry faces. Because thirdparty overlay managers have their own propri-etary expert systems, there are no organiza-tional constraints on the values to be addressedand managed, on investment products used oron the technology which can be brought tobear. This greatly mitigates the inefficienciesand the inherent technological constraints ofoutdated legacy systems tied to trade executionthat stunt innovation and plague the financialservices industry. Importantly, overlay manage-ment will facilitate the unbundling of research(buy and sell recommendations) andaccount administration from the assetmanagement function. This will givefirms that have scale in separateaccount administration, like CitigroupAsset Management ($66 billion), anopportunity to use account administra-tion cost, pricing and investment mini-mums as a means to grow and perhapsdominate the managed accountindustry. Citigroup Asset Management,already the largest separate accountmanagement firm, could easily becomea top five asset management firm asmanaged accounts and overlaymanagement disintermediate otherforms of investment which are morewidely used today. Overlay manage-ment would empower all financial advisors toadd value which, in turn, places a heightenedimportance on managing accounts, greatlyaccelerating the growth of the managedaccounts industry as a core mainstream invest-ment vehicle.

Little did Peter Cieszko and Stuart Parkerexpect when Citigroup Asset Managementintroduced the multi-discipline account (MDA)that in it were the seeds of innovation, whichwould not only significantly change the assetmanagement industry, but could possibly posi-tion Citigroup Asset Management as one of thedominant players in the fast-evolving assetmanagement industry.

The MDA introduced two very importantinnovations: (1) composite performancereporting of multiple managed accountmanagers as though they were one account and(2) the creation of a third level of professional

asset management − overlay management −which managed a level of client-specific detailnot possible by the money manager, that goesbeyond the technical capability of most advi-sors.

Initially, composite performance reportingmade the big splash when MDAs were firstintroduced because it held the promise ofsaving advisors hundreds of manhours a year inusing an Excel spreadsheet to incorporate allclient account holdings into a performancemonitor. But because the scope of the MDAreporting was limited just to managedaccounts, its application was limited to thoseadvisors working the institutional market orusing MDAs as a core portfolio position.

Ultimately, virtual income statements andbalance sheets, and account aggregation (ByAll Accounts, Yodlee, eVare, Adhesion,Statement One) will resolve the challenge ofreporting on all a client's holdings custodied atmultiple institutions. But the innovation thatchanges the financial services world, as weknow it, is overlay management expanded toincorporate all client assets, custodied at allsources, which addresses and manages allvalues, either cited by the investor (incorpo-rated in the investment policy) or requiredunder regulatory mandate. Expanding overlaymanagement beyond the MDA changes thefinancial services industry in profound ways as,for the first time, it facilitates all financial advi-sors to add value without necessarily having tohave an extraordinary set of skills.

Overlay management greatly elevates therole of the financial advisor in adding value.

The financial advisor simply has to be able toevaluate and articulate the needs, goals andobjectives of each client to the overlaymanager, typically taking the form of a state-ment of investment policy. The overlaymanager not only directly assumes the respon-sibility to manage the aggregated buy-and-selldecisions of a large number of asset managersbut, through expert systems, also managesvalues like risk, return, tax efficiency, liquidityand cost structure with a degree of technicalcompetency and sophistication not possible bymost financial advisors. This assures the fullrange of investment and administrative valuesare being addressed and managed as requiredunder regulatory mandate (UPIA, ERISA,

MPERS, Proposed Uniform TrustCode) and/or client instructions. Thus,through overlay management, thefinancial advisor is empowered toprovide the highest level of profes-sional investment and administrativecounsel without being bogged down inthe technical and administrativeminutia of advice. With overlaymanagement, the advisor is not put inthe awkward situation of having toknow how to build a clock, they simplyhave to know how to tell time. This isthe long awaited innovation that willmake it possible for all financial advi-sors to add value. In doing so, growthin the managed account industry is nolonger constrained by the number of

financial advisors adept at taking full advan-tage of the differentiating strengths of managedaccounts in portfolio construction. Withoverlay management, the tax lot accountingavailable in a managed account is fully utilizedand becomes central to managing tax effi-ciency. The style discipline of a managedaccount, which is so important to the overlaymanager in managing risk and return, becomescentral to portfolio construction. The low coststructure of a managed account, which is justone-third the cost of a mutual fund and is soimportant for a fee-based advisor and anoverlay manager in having the latitude to pricetheir services, becomes central to facilitatingadvice and central to portfolio construction.Thus, with overlay management, CitigroupAsset Management, the largest managedaccount manager, is poised for extraordinarygrowth because all investors prefer value to be

Expanding overlaymanagement beyond the

MDA changes the financialservices industry in

profound ways as, for thefirst time, it facilitates allfinancial advisors to add

value without necessarilyhaving to have an

extraordinary set of skills

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who advise 25% of all U.S.-based assets justaccount for one-half of 1% of all licensedfinancial advisors. There are simply not enoughfinancial advisors adept at addressing andmanaging a broad range of investment andadministrative values to serve all investors whowish value to be added. Overlay managementis the solution in empowering the other746,000 (or 246,000, depending on how youcount) licensed financial services professionalsto address and manage a broad range of invest-ment and administrative values as required tofulfill our fiduciary obligation. Overlaymanagement puts high level, comprehensive,expert advice in the reach of every financialadvisor who wishes to add value for theirclients.

When we speak of overlay management, weare speaking of it in its most advanced state,going beyond the services initially incorpo-rated in the MDA. Technically, if you simplyprovide a composite performance report onmore than one money manager, you are anoverlay manager; but the value of the overlaymanager is in managing a level of portfoliodetail that is either too cumbersome or too tech-nical for the advisor to handle. In its mostpowerful form, the overlay manager zeroes inon trade management, coordinates andimproves of tax lot management, coordinatesaccount rebalancing and risk management,while using proprietary systems that are typi-cally not available to most financial servicesfirms. The overlay manager avoids de minimustrades, exchanges stocks or tax lots amongmanagers, when appropriate, and absorbs and

added, and many of those values are bestaddressed and managed through managedaccounts. Since managed accounts incorporatetax lot accounting, which allows tax efficiencyquestions to be resolved, and style discipline,which allows risk and return to be managed inportfolio construction, and because neither ofthese disciplines are structurally present in amutual fund, the overlay manager concept isthat mechanism that will take the managedaccount industry from $0.5 trillion in assets to$5 trillion in assets over the next five years.

The overlay manager takes us beyondconventional wisdom to a new level ofthinking. Consider the challenges that financialadvisors and asset management firms facetoday in adding value at the client level. Mutualfund companies, under the 1940 Act,must manage money in accordance tothe stated goals and objectives in theprospectus and cannot address thespecific needs of each investor. Yet, theadvisor who understands the needs ofeach investor, does not have access tothe processes and technology necessaryto be responsive to those client needsand/or does not have the personalinterest and/or the skill set to addressand manage a broad range of invest-ment and administrative valuesrequired in order to add value. If themoney manager cannot add value foreach individual investor and the finan-cial advisor does not have the skill orresources to add value, then the overlaymanager does and can add value in a scale thatinvestment management consulting has notbeen able to effect.

In principal, investment managementconsulting has been the answer in adding valueat the client level. By building or gainingaccess to the process (asset study, investmentpolicy, strategic asset allocation, managersearch and selection, performance monitor,tactical asset allocation) and technology(account aggregation, Monte Carlo simulation,gating technology tied to investment policy,subaccounting, trade and order routing andreporting, real-time style attribution, invest-ment methodology) necessary to add value,today, a small number of early adopters areadding value for their institutional and high networth clients. But these 4,000 senior invest-ment management consultants (our readers)

delivers stocks from a core position whereappropriate. They maintain tax lot information,sell the best lot if held by more than onemanager, harvest tax losses, police wash sales,defer gains from short-term to long-term andmatch losses and gains when required. Theyallocate cashflows, contributions and with-drawals, transition securities into and out of theportfolio, transition holdings on managerreplacements and rebalance manager and assetclass weights. They balance risk against taxbenefits and the cost of missing targetedperformance metrics, ensure the entire port-folio is within the guidelines of targetedmetrics and ensure the entire portfolio is withinthe specified market metric.

Overlay management greatly elevates thelevel of counsel and the investmentconsiderations advanced with the clientas the financial advisor manages theprocess in which value is added,defining the rules, parameters,constraints and metrics in which theoverlay manager works within. Theadvisor determines an acceptable rangeof tracking error, how to rebalanceholdings, how to harvest tax losses,etc., all from a range of options. Thefinancial advisor essentially ismanaging all the associated nuances ofthe values being addressed andmanaged, which is a very highly valuedskill set. But, as much as the overlaymanager elevates and enhances the roleof the financial advisor, it has an even

larger impact in reducing the cost of assetmanagement and reducing and streamlining thecost of account administration.

The administration cost of a separatelymanaged account is notoriously expensive forboth asset management firms and brokeragefirms. Every brokerage firm has their ownsystem and methodology to administer amanaged account. This requires the assetmanagement firm to create and staff customadministrative interfaces for each brokeragefirm intermediary whose advisors wish to use/engage the asset management firm's services.There as many as four parties (the financialadvisor, the advisor's broker/dealer, a thirdparty managed account manager sponsoringplatform and a custodian), which require themanaged account manager to manage as manyas four new account procedures, four trading

Overlay management is thesolution in empowering theother 746,000 ... licensed

financial servicesprofessionals to address

and manage a broad rangeof investment and

administrative values asrequired to fulfill our

fiduciary obligation

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and trade reconciliation systems, four reportingsystems and four client service functions foreach account. At the client level, brokeragefirms have a more complex problem becausethe average investor has 16 financial relation-ships that must be tracked and incorporatedinto reporting in order for it to be possible forthe advisor to add value. Because of thecomplexity and expense of account administra-tion, separate account managers are fortunate ifthey can net as much as 18 basis points fromtheir 38-50 basis point asset management feeafter deducting the cost of having one portfoliomanager for every 500 accounts and the cost ofproviding often duplicate new account, trading,trade reconciliation, reporting and clientservice functions. Given that theindustry has been slow to embrace totalenterprise technological solutionswhich would entail new web-basedtechnology (Market Street Advisors)which can cut 15 to 20 basis points outof separate account managementadministrative cost, overlay manage-ment interjects a new model in whichextraordinary administrative efficien-cies can be more readily achieved. Thisdoes not mitigate the need for moreadvanced technology, but overlaymanagement accelerates the develop-ment of more efficient technology bycreating very powerful economicincentives for leading brokerage firmsand managers to innovate.

Rather than having to contend withso many disparate systems andrequiring so many portfolio managers(one per 500 accounts) for tens of thousands ofaccounts, most asset management firms wouldbe perfectly happy to sell their research, i.e.,their real-time buy-and-sell recommendations,for 18 basis points, to an overlay manager whowould, in turn, interface with brokerage firmintermediaries. Brokerage firms would engagethe overlay manager (Parametric, Placemark),for 15-18 basis points, to assume fiduciaryresponsibility, construct and manage custominvestment portfolios in accordance to regula-tory mandate and the specific values andinstructions cited in investment policy for eachclient, working with all the client's assets andliabilities. The brokerage firm would act ascustodian and provide all account administra-tion and support for 15-18 basis points. This

would result in truly customized portfoliomanagement, where the full range of values(risk, return, tax efficiency, etc.) would beaddressed and managed using auditable, expertsystems, for a total of 50-55 basis points. Thevalue proposition to the client and the financialadvisor would be extraordinary. The advisorwould not have to understand all the nuances oftax efficiency, UPIA or portfolio constructionin order to add value. The client would not payany more than normal for a traditional managedaccount at 50 basis points, and brokerage firmswith scale such as Citigroup AssetManagement ($66 billion in separate accountassets) would become a magnet for assets.Citigroup Asset Management could use its

economies of scale in account administration todrive down both managed account investmentminimums to below $50,000 and pricing,which would drive all but the most efficientorganizations out of the managed account busi-ness. This would not only be good for theconsumer and Citigroup Asset Management,but it would force the industry to embrace newweb-based technology which will lead to evenmore efficiencies. Senior Consultant estimatesCitigroup Asset Management managed accountadministration cost at significantly less thanfive basis points. So, firms whose actual costsare running 15-20 basis points would be welladvised either to outsource their managedaccount business to Citigroup or to adopt farmore efficient web-based technology. In

outsourcing, firms would gain access to a supe-rior value proposition, would not incur oneroustechnical and administrative responsibilitiesand, as a smaller firm, would not have to worryabout achieving scale or competing withpricing that comes with scale.

With the unbundling of research (themanager's real-time buy-and-sell recommenda-tions) and account administration from sepa-rate account management, many of theoperating inefficiencies of the managedaccount business will be resolved, cost will bedriven down and the associated technology willeventually be commoditized. Thus, the role ofthe overlay manager who is actually managingthe values important to each investor becomes

the focal point in the industry's abilityto add value. Dr. David Stein, chiefinvestment officer of Parametric, hasquantified the value added by overlaymanagement on overall portfolioperformance to be 35 to 100 basispoints. (See “Overlay PortfolioManagement in a Multi-ManagerAccount,” Senior Consultant,November/December 2002.) In an erawhere it has been difficult to beat theindex, enhancing performance by 35-100 basis points is truly extraordinaryby any measure. The overlay manageris the whole product solution necessaryto empower all financial advisors toadd value but takes a totally differentform than those of us in early involve-ment with investment managementconsulting would have imagined. Theconsulting community would like to

see electronic asset studies, electronic policystatements, electronic manager search andselection, and electronic performance reportingbecome universally accessible so it is possiblefor all advisors to add value. But all financialadvisors do not have the skills to execute;instead, the overlay manager will add value forthe advisor. Rather than cheapening consulting,it elevates the dialogue and points of discussionof all financial advisors. However, ultimately,in order to differentiate their work and enhancetheir value proposition, all advisors will gravi-tate toward an electronic asset study, an elec-tronic policy statement, an electronic managersearch and selection engine and an electronicperformance monitor, as we would have antici-pated, because it integrates the investor into the

Overlay management is abreakthrough that

empowers all financialadvisors to add value and

will ultimately lead allfinancial advisors to use

electronic versions of thesix financial services

investment processnecessary to add value and

as is required byregulatory mandate

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Senior Consultant1457 Crystal Springs LaneRichmond, Virginia 23231

Ph 804-643-1075 Fax 804-643-1544WWW.SRCONSULTANT.COM

S E N I O R C O N S U L T A N T

James P. OwenCo-Founder

Stephen C. WinksCo-Founder, Publisher & Editor-in-Chief

Sydney LeBlancConsulting Editor

Mamie Woo McNealProduction Editor

Eddie BryantMarketing Consultant

Advisory BoardJerry Bott

Merrill LynchJohn Brock

Brock-Hazzard/First Union SecuritiesDick Charlton

New England Pension ConsultantsBob Cluck

Canterbury CapitalHarold Evensky

Evensky Brown & KatzJeff Frum

Wells FargoRich Gleason

Salomon Smith BarneyKathleen E. HegenbartSalomon Smith Barney

Brian HunterPrudential Securities

Greg HunterAlex BrownBill Johnson

CapTrustJohn Kelsey

Salomon Smith BarneyKeith Phillips

Morgan Stanley Dean WitterBob Rowe

Morgan Stanley Dean WitterDick Smith

Capstone Investment GroupJim Yanni

Yanni Partners

investment process, which maximizes the valueadded.

Overlay management is a breakthrough thatempowers all financial advisors to add valueand will ultimately lead all financial advisors touse electronic versions of the six financial serv-ices investment process (asset study, invest-ment policy, strategic asset allocation, managersearch and selection, performance reporting,tactical asset allocation) necessary to add valueand as is required by regulatory mandate

because it deepens the client relationship,fosters the client perception that value is beingadded, and in fact, maximizes the value of thefinancial advisor's counsel. Overlay manage-ment is an important intermediate step in thefinancial services industry at-large, empow-ering all financial advisors to compete on thetangible, quantifiable investment and adminis-trative basis of the values they address andmanage.

Senior Consultant

THE VOICE OF THE INVESTMENTMANAGEMENT CONSULTANT

Notes