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News August 28, 2006 Issue

Compliance Issues Raised by MSP and UMA Accounts (Part 1 of 2)

Advisers that serve as external managers or overlay managers in multi-style portfolio accounts (MSPs) or unified managed accounts (UMAs) are grappling with a number of compliance-related questions.

For example, how should assets invested through those programs be counted for purposes of Form ADV assets under management? What about GIPS? And what if an adviser discovers that the much-vaunted "overlay management" feature of these accounts occurs only after the external managers enter in trades? Isnít finding a wash sale thatís already occurred like shutting the barn door after the horse has galloped down the lane?

Karyn Vincent of Vincent Performance Services reports receiving many questions from her clients about these issues. "The frequency has definitely increased," she said. "I think thatís partly due to the continued growth of overlay programs and the number of managers involved in them." Investment Adviser Association general counsel Karen Barr also reported that her groupís members are raising questions about these types of accounts, particularly with respect to the application of the GIPS standards.

Whatís an MSP or UMA, anyway? Because MSPs and UMAs are relatively new products, letís start with a basic explanation of what they are and how they work.

But first, a preliminary point: Donít call them "MDA" accounts. Weíre told that "Multiple Discipline Accounts" is a product name trademarked by Smith Barney (a call to the firm requesting confirmation of that fact was not returned by press time).

Think of an MSP account like a wrap account managed by more than one external manager. A customer opens an MSP account at an MSP sponsor, which could be a national wirehouse, regional broker, bank, or third-party distributor, such as SEI. The sponsor then splits the management of the money in that account into a number of pieces, with each piece separately managed by an external money manager. However, the sponsor serves as the "central marketing force" and the "central interface to the investor," explained Dan diBartolomeo, president of Northfield Information Services.

The main difference between an MSP and a UMA seems to be the fact that UMAs may also hold ETFs and other registered investment company products.

The customer pays a bundled fee for advice, brokerage, and custody. So, legally speaking, these accounts are wrap programs and accountholders are provided with Schedule Hs.

Now, for the twist: Under the theory that too many cooks in the kitchen can spoil the soup, most MSPs and UMAs feature an overlay component, in which yet another manager keeps an eye on the overall composition of the account. "If manager A is doing its thing and manager B is doing its thing, and they each donít know what the other is doing, you could obviously create a transaction that is very tax disadvantageous," diBartolomeo noted. "You put in the middle of this a traffic cop, who is called an overlay manager." The overlay manager takes the recommendations issued by the external managers "and somehow synthesizes the strategy for the whole thing."

In some instances, the MSP sponsor may act as the overlay manager. More commonly, however, the sponsor contracts out the overlay responsibility to yet another independent manager.

Overlay management is particularly important when the different slices of the account have overlapping or potentially conflicting holdings. For example, said diBartolomeo, if the MSP account contains a growth portfolio and a value portfolio, the two external managers occasionally find themselves at odds. If a company announces a significant decrease in its earnings, the value manager may want to buy it and the growth manager may want to sell it. If both managers enter such trades, with no coordination, the investor potentially faces a taxable event, namely, a wash sale.

The overlay manager also typically monitors for across-the-account overweightings that may not be visible to managers focusing on their specific portfolio.

In addition, the overlay manager typically provides the Rule 3a-4 account customization. While representatives of the sponsor may sit across the desk and work with customers to complete the typical account opening questionnaires, it is the overlay sponsor who receives that information and is responsible for customizing the underlying external managersí recommendations for each specific client. Itís the overlay manager, said Morgan Lewis of counsel Monica Parry, that is responsible for remembering that "Mr. Jones doesnít want tobacco in his portfolio or that Ms. Smith wants to take some tax losses."

In most cases, the external managers are not responsible for tailoring their recommendations for the individual clients. Typically, said diBartolomeo, external managers "cede that customizing responsibility to the overlay manager."

According to diBartolomeo, there are "lots of ways" of providing overlay management. Some overlay managers use a manual, "seat of the pants" approach. Others use a more analytical, mathematically-driven approach. The method chosen by a particular overlay manager, he said, may depend on "how sophisticated they are, how homogeneous the clients are, and how big the fees are."

A few other things to keep in mind: Not all MDA accounts have an overlay manager. And overlay can be used even when thereís only one external manager. That one manager might say, "Iím good at picking stocks" and decide not to focus on the individual client issues, leaving that to an overlay manager, explained diBartolomeo.

The Big Looming Compliance Issue. Some MSP/UMA programs are set up so that the underlying external managers have discretionary authority to enter trades directly on the sponsorís platform. In other words, each manager has final authority to pull the trigger on trades for its portion of the account. While the overlay manager will review such trades, it does so only after the fact.

If your firm is involved in one of these programs, we suggest that you grab a copy of the program client contract and marketing materials. Are you satisfied that those documents very clearly indicate to accountholders that the overlay management services will occur only after trades have hit their accounts? For example, do the materials make clear that overweightings will be corrected only after the fact? And that taxable wash sales may not be prevented?

If your firm finds itself participating in such an "overlay-after-the-fact" program, you may want to consider your obligation to speak up about any concerns you might have. This is definitely an issue to talk to your favorite lawyer about. But whatever you do, donít be a "potted plant" and acquiesce to a situation where you know that clients have been told one thing about the services they will receive but are, in fact, receiving a different set of services.

Assets under management. The answer to how assets managed in a MSP or UMA account should be treated for purposes of assets under management will depend on the nature of the services provided. Since the roles of the overlay manager and the external manager vary from program to program, a CCOís first step should be to nail down the exact nature of his firmís responsibilities.

Letís look at the role of the overlay manager first.

This oneís pretty easy: At the end of the day, the overlay manager is being paid to fret over the account, all the time. If thatís not providing "continuous and regular supervisory or management services," we donít know what is.

IM Insight has confirmed with two leading industry attorneys that an overlay manager typically will be able to count assets invested in the MSP or UMA accounts as assets under management for purposes of its Form ADV.

And it really shouldnít matter whether the overlay manager has discretionary authority to wade in and adjust the account, for example, by rebalancing the account or investing new cash. Regardless of whether the overlay manager has discretion to do something about any issues it spots, or whether it has to go back to the underlying external managers to get them to address the problem, itís a safe bet that it will be deemed to be providing "continuous and regular supervisory or management services" to the account.

So that was easy.

The case of an external underlying manager is a bit trickier. If the underlying manager effectively acts like a traditional portfolio manager, because it is directly connected to a platform, it would seem that such a manager could count those assets as AUM.

But, as noted earlier, thereís a far bigger issue: Do the programís marketing materials fairly describe the nature of the overlay services? As noted earlier, if your firm finds itself in this situation, youíll probably want to talk to a lawyer.

The far more common scenario, however, is one in which the external managers hand over their model recommendations to the overlay manager, who implements them. Before doing so, however, the overlay manager screens for wash trades and overweightings and checks against client restrictions.

Unfortunately for the external manager, it probably shouldnít count those assets as assets under management. See, for example, the staffís analysis of the facts in the recent Credit Agricole no-action letter. There, a manager that handed over recommendations to another manager that had ultimate authority for pulling the trigger on the trades was deemed not to be providing continuous and regular supervisory or management services.

And donít draw too much comfort from the SECís recent auto-trading cases, such as Weiss Research. Aside from the fact the one should never lean too heavily on settled enforcement cases for legal precedent, the facts in those cases were different: the models were hard-wired to the brokerage accounts, with no other manager interposed as a layer of review prior to execution.

Lastly, can sponsors count MSP/UMA assets as their own assets under management?

If the sponsor is doing little more than collecting the client information and handing management of the account over to underlying external managers and the overlay manager, it would seem to be a stretch.

Next week: GIPS.