XMA: Extremely Managed AccountsEdit
We all know, volatility is the latest virus, the financial industry is facing. We need to team-up and revisit the history of evolution in the field financial management to be able to understand the problems we came across and the solutions we built. This will help us engineer solutions to the current problems without losing sight of the context.
Over the past few decades, we have managed two facets of finance successfully, namely Accounts and Growth. Let’s look at these closely without getting into numbers and charts, thus keeping it all simple.
We have seen the concept of Managed Accounts move from Mutual Funds, to a Separately Managed Accounts model.
Mutual Funds are centrally managed portfolios that are bought and sold as units of portfolio. These central units provide diversification across multiple securities. But this diversification typically is confined to one asset class. As the market volatility bled into a single sector or asset class, the industry needed diversification across asset classes or sectors. Furthermore Mutual Fund management activity is too discretionary and too opaque for the advisors and end investors to accept.
The concept of Separately Managed Accounts (SMA) is a variation of this central management concept that adds diversification across various asset classes. This model became very successful as the market volatility was hedged by strategically mixing weights of various asset classes. Management of Separate Accounts (SMA) was more transparent than was Mutual Funds management, as a result market found them easy to accept and observe. Customization of SMAs was also more flexible in nature. Lately volatility in the market found a way to penetrate the boundaries of asset classes. SMAs are finding themselves a prey to this latest market trend.
Alongside this trend from Mutual Funds to SMAs in the managed accounts podium, also saw a shift from commission-based business models for various broker-dealers, to transform into a fee-based paradigm. One major explanation for this shift has been the concord of interest between the advisors and their clients where the advisors income is coupled with the growth of the investments.
Managed Accounts industry has lately been battling the challenges with volatility by extending diversification into avenues like Alternatives. Alternatives today are as opaque as Mutual Funds once were, when it comes to management. Advisors have been reluctant to embrace this solution and find themselves in a difficult position to explain to their end-investors. So the growth in this fairly new venture has been slow and acceptance of this model is scant.
In summary, volatility is today’s enemy. Some of the key features of managing accounts have been transparency, customization and the sense of secure management coupled with the advisors’ vested interest in their client’s account growth. Alternative Investments moves the industry forward in areas like diversity but takes it back in the areas of transparency of management. Furthermore it is a tactical budge and is only a matter of time, before the volatility finds a way to hemorrhage into the Alternatives market as well.
It is only in the best interest of the industry to not buy all into the Alternatives model, but only keep it as another way to hedge for short term until a long-term workable solution is devised. The only question is how long will this wait need to continue and who will take the initiative towards an invention. At this time, any and all ideas need to be considered until a clear direction is achieved as the curtains on the theatre of war are yet to fall.
End investors are always and only concerned about growth. They pay advisors, commissions and fees with this objective in mind and growth is the only goal set with their advisors. Failing to deliver on this aspect will defeat the confidence and contract between these two players.
With this in mind, advisors began facing the slow, manual market with purchases and redemptions needing time. Reaction to the market movements seemed leisurely. Advising and managing growth witnessed protraction. It was a difficult time and considering that, there was sustained confidence between all roles, until the market succumbed to the needs of alacrity. Markets became electronic and investors took it into their own hands, a few managers and advisors did too.
Trading rapidly and highly reactively became predominant. Investors often trading through the day, made very hasty decisions in an attempt to catch-up with the market movements. Day-trading as it became known made a few rich and brought many down. Furthermore, this mode of management became very involved and expensive, as it constituted truly tailoring the purchases and redemptions for each account. Managing growth became a challenge all over again until the industry taught itself discipline in Growth Management.
In the name of discipline, strategy became well-known as long-term, as much as extending the definition of patience. It invented portfolios and brought the concept of master-slave into the growth management perspective. So discipline for this phase of management not only meant not reacting to the market but also saw the paradigm of following a portfolio as a commoditized way of growth management. Industry believed, until the markets proved bearish for very long periods. Answering investors was only one worry for the advisors; the worse concern was having the same answer for all the questions - demanding patience every time. It did not work for very long. Eventually, the industry surrendered to newer approaches to managing growth.
One of the approaches was to limit the strategic discipline to a shorter period. This allowed the industry to keep the mass management traits and also permitted reaction at the same time as retaining discipline. We called it Tactical Management. This was highly impossible in commission based business as the turnover was large and became possible only with fee-based accounts. This was still not sufficient for the needs of the industry as the market learnt a new trick towards entropy, through volatility.
If we try to understand volatility, it essentially impairs the ability to manage multiple accounts using one portfolio. In other words what was true one day is not likely true for the next day. So if one uses portfolios to manage such a characteristic, accounts that bought into the portfolios one day may perform well, whereas the accounts that try to follow the same portfolio the next day may be harmed.
For instance, one account’s position purchased on a day will lead to an evaluation of sale in the next month for that position. For another account though, purchasing the same position on the next day, will evaluate to a need of sale in two months. This is by the nature of the rapid market movement for a position from one day to another. This behavior defeats the concept of mass management in the milieu of achieving growth.
So a solution will need to be fabricated, that will be a hybrid between day-trading, strategic and tactical management for growth. It will need to be tailored for individual accounts but not go so far as intra-day, thereby retaining discipline.
We have come to a point of convergence between the topics of Account Management and Growth Management in light of volatility. We need a solution that will work in this market of this age. We need to be able to manage accounts with similar infrastructure as the industry has laid-out in the form of broker-dealers. An otherwise major infrastructure change will fright the industry. We need to be able to manage growth with speed and discipline at the same time as combating the volatility.
Examining the roles played by the current infrastructure, we find Broker-Dealers, Advisors, Investors and Portfolio Managers. We need to keep all these roles intact but revisit the role played Portfolio Managers.
Portfolio Managers supply collections of securities addressing a need such as an asset class. This collection has a prescription in the form of weights. This prescription establishes the fine balance between discipline and change. We will need a new mode of operation, where Managers serve using algorithms and diligence rather than a portfolio. These algorithms will need to examine the collection of securities for each account, their purchase dates and their costs to be able to determine the reactionary advises. The more often this occurs, the better. This will of course add a lot of responsibility of active management as well as tailored management.
A broker-dealer or a managed account platform will need to supply information about each account, its positions and its cost along with other key factors to the Managers every night, so the Managers can churn their algorithms and diligence to advice on the next measure for each account. This approach will need further sophistication from the Managers and their firms. Or they will need to get help from other TAMPs to sophisticate their systematic processes to manage thousands of accounts every night. It is high time we find alternatives to Portfolios and with the above approach; it will turn back into algorithms and diligence.
We will accomplish confining to Account & Growth Management, with reactive management retaining discipline and tailor-made for each account. Volatility will be defeated and may even help in this case because of each account analyzing its own position. We will still retain the industry infrastructure with one change on the Portfolio Management plane.
This concept can also be extended to having a pool of Managers and give the advisors the ability to choose them, as they infer their algorithms and diligence.
Can we call this approach Extremely Managed Accounts, XMA? Not that I say!