Diversify, Diversify, Diversify – 3 Ways to Help Advisory Products Succeed in Volatile Markets

“How can clients improve diversification in their portfolios?” was the question Roger Paradiso posed to those attending this session at the MMI Tech and Ops Conference 2011.  Client’s portfolios aren’t performing as expected and their needs aren’t being met, he said, they are looking for solutions. The recent rise in volatility in the market, he explained, combined with the correlation of many previously uncorrelated asset classes, has increased the priority of diversification for many investors.


Roger Paradiso, President and Chief Investment Officer, Private Portfolio Group, Morgan Stanley Smith Barney


Mark Thomas, Senior VP, Head of Managed Accounts, PIMCO
Joe Mrak, CEO, FolioDynamix
Donna Davis, Director of Trade Management, Private Portfolio Group, Morgan Stanley Smith Barney

Alternative investments help to diversify portfolios. How are you introducing alternatives into advisory solutions?

PIMCO uses a forward-looking process when designing client solutions, Mark explained. They evaluate what vehicle, product or platform makes sense and decide on the right structure for each client. Support for 40Act funds, limited partnerships, private funds, and separate accounts are all included in their program.

One issue when introducing new products is ensuring that there is enough capacity, Mark said. PIMCO is continually looking for ways to lower the minimums in their alternative structures and vehicles to make them available to a wider audience.

What are you doing in terms of alternatives?

Alternatives are a hot topic now, but interest in them goes up and down like the volatility in the market, Joe cautioned. FolioDynamix currently works with 50 bank and broker-dealer clients and they have been expressing interest in alternatives.

One of the most difficult aspects of handling alternative is due diligence, especially with hedge funds and funds of funds. This issue can be avoided by using mutual funds and ETFs that fulfill alternative asset classes (i.e. absolute return, long/short, real return/market neutral products), Joe explained.

More and more they’re seeing clients trying to blend annuities into their managed accounts portfolios, especially UMAs, Joe commented. There is a big movement from firms that service IBDs and the RIA channel to add alternatives that we’ve never seen that before.

Roger added that from an MSSB perspective, they’re going out to their hedge fund partners to help them get into structures that they need on these type of platforms.

Does your firm use 40 Act vehicles?

According to Mark, PIMCO has a number of alternative 40 Act funds, like their commodity real return funds that provides exposure to the broader commodity indexes, real income funds, others that utilize tail risk, etc. There is a requirement to constantly “feed” their style boxes, since the pool of managers is always in a constant state of flux. This includes managers that are closing, managers that are changing their strategies and managers that are being terminated from their program. This constant flow of managers in and out of the program must be monitored. Mark conceded that it’s a challenge is to get 40Act funds pushed through onto a platform that has a 60/40 modern portfolio theory asset allocation structure.

How difficult is it to implement international securities in your portfolios?

Morgan Stanley always tries to figure out what is the best fit is for managers in the international space, Donna said. If the money manager trades only foreign ordinaries, for example, they’ll speak to the traders and figure out how to get the them in without bringing them into the firm because they can’t settle any non-USD issues.

Foreign ordinaries that don’t settle in USD can be converted into an ADR, Donna acknowleged. They’ll work with portfolio managers to answer all outstanding issues such as the amount of liquidity in the marketplace and whether or not they are able to trade the overnights in the issuing countries. They have to post these trades to the client account as USD, especially in UMA, otherwise it will cause issues with the other sleeves, Donna contended.

Instruments such as ADRs, ADNs, GDRs are clean as long as we have enough liquidity. For securities that trade on pink sheets or that only trade on foreign exchanges, we’ll build an order, give it to our trader who executes our overnight strategies, and they bring it back to us the next morning.

Joe reported that his firm has stepped back from including foreign ordinaries because there are so many good ADR products available.

The biggest problem with handling foreign ordinaries is exchange rates, Donna insisted. If you can’t convert the trade back to USD, it’s not worth it. This is especially true at Morgan Stanley, she emphasized, because they are not able to handle performance calculations for trades that don’t settle in USD.

As an investment manager, we’d like to pool all of our alternatives assets and hard-to-trade securities inside a completion fund or FISH-type product. What are the operational hurdles of doing this inside of an SMA product?

Dealing with a FISH or SMASH fund inside an SMA shouldn’t be a problem, Donna said, when you consider that they are just a mutual fund with a long position kicker. You need to look at the pricing and performance structure of the mutual fund and couple that with the long position. That can be made into a sleeve and then calculated at the total performance by rolling up the mutual fund and each individual long position, she explained.

Joe agreed and said that his firm encourage customers to move to a FISH structure, if they can. It makes the underlying securities easier to trade, so it’s a better solution for a lot of illiquid fixed income products that are out there, he said.

The FISH product was initially developed at Allianz when Mark worked there back in 2001, he said. The structure creates a lot of efficiencies for the portfolio management team, assuming you can get the scale and product relatively quickly, since there are operational costs to opening 40Act funds, he said.

Before FISH were available, it was a massive effort to get these fixed income products into an SMA, Mark explained, because you had to go to every sponsor and make sure that they could limit the access to a zero-fee fund that requires very tight controls around trading. You also have to make sure that they cannot be transferred (via ACAT) to firms that do not have the ability to track them correctly, he warned.

PIMCO is looking to build new FISH products that support muni accounts, since it would enable them to hedge away some of the duration risk in those portfolios. FISH would provide access to sources of alpha at lower minimums as well as diversification and the ability to get into different areas of the market.  Combined with the firm’s zero fee structure for FISH makes them an incredible solution, Mark said.

Versions of FISH are often used at PIMCO for separate accounts with assets in the $100mm-300mm range in combination with sector funds. Because of the available volume and liquidity, these size clients often use sector funds to get into cash or emerging market debt, Mark emphasized.

What are your clients requesting regarding fixed income support in managed accounts?
There’s a lot of mutual fund and ETF products that can fulfill fixed income style requirements, Joe responded. Mainly because they’re easier to package and easier for reps to sell.

Joe told us that they receive many requests from clients for traditional SMA fixed income portfolios.  They have been seeing a lot more demand for traditional fixed income SMA products as opposed to fixed income in UMAs.  While they do a lot of UMA business, they only have 2 or 3 model portfolios for fixed income.  Fixed income portfolios require more operational effort, especially around allocations and delivery/processing of nightly files, he stressed.

Reps now want to trade individual bonds, Joe said, but most vendors in this space don’t support it, so they go to third parties like BondDesk.  His firm is looking at integrating with one or two bond ECNs and also developing a characteristic-based fixed income modeling support in their Rep-as-PM product.

There aren’t many operational hurdles for UMA to trade fixed income, Donna contended.  They can pass off the position to the fixed income manager and let them trade it any way they want.  The biggest point that could cause problems is that fixed income managers often want to use their own pricing service. They want to shadow every transaction and recalculate everything, she said.

These are the type of sophisticated products that must be delivered seamlessly if the industry is going to be successful in a UMAUMH environment, Roger advised.

FISH has been a very successful product. Any opinion on why it hasn’t been successful in other areas besides fixed income?

The first SMASH product was built at Westin and it was extremely expensive to build, Donna said.  There are numerous factors including accounting and transfer agent charges, which makes them very expensive.  Due to the high cost, they only built four products and never built another one after that, she admitted.

From a marketing perspective, client’s opinion of SMAs took a hit after the financial crisis, given that they weren’t flexible enough to handle the huge shifts that occurred in the market. How much of your business has shifted from SMA’s into UMA platforms?

A lot of clients request new products to replace their SMA programs, Joe said.  They want something that’s packaged better, is easier for reps to sell and easier to do compliance.  For this reason, they are seeing a lot of flows out of SMAs into mutual fund wrap products.  One of their clients launched a mutual fund that was more like an ETF wrap product and it turned out to be quite successful.  It provides them with tremendous flexibility to go after $50K clients as well as $1mm clients.

Do you support Rep as PM inside UMAs?

According to Joe, Rep as PM is the #1 request of FolioDynamix clients, especially for those that recruit advisors out of the wirehouses where they have technology that allows them to “roll their own”.  The FolioDynamix UMA system supports an RPM sleeve that an advisor can manage as part of their own asset allocation.  This allows advisors to implement core-satellite strategies and focus on the areas where they have expertise.  Clients can then convert these advisory-run strategies into a tear sheet, using their proposal system, and can then deploy it out to the field, he explained.

There are tremendous benefits from RPM, especially for strategies built by home offices that don’t fit into traditional style boxes, Mark responded.  At the same time, it’s concerning, because some advisors don’t have the necessary experience to determine the appropriate asset allocation for their clients.  Asset allocation is an underrated skill and is becoming increasingly difficult as the investment environment changes, he warned.

Ten or fifteen years ago, Mark explained, the industry moved advisors away from picking stocks.  Now, he feels that things have shifted back to advisors creating asset allocations and/or picking stocks in RPM platforms.

Some critics say that RPM only exists in order to justify charging high fees in low fee/low return environment.  It is true that there isn’t much benchmarking of RPM performance when compared to investment managers (such as PIMCO) who are measured regularly against clearly-defined benchmarks.  Firms that offer RPM to advisors should take steps to ensure that their clients are seeing results comparable to outside money managers.

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The Wealth Tech Today blog is published by Craig Iskowitz, founder and CEO of Ezra Group, a boutique consulting firm that caters to banks, broker-dealers, RIA’s, asset managers and the leading vendors in the surrounding #fintech space. He can be reached at craig@ezragroupllc.com