Benefit of diversification in separately managed accounts

A Separately Managed Account, or SMA, is an individual investment account typically offered by a brokerage firm and managed by an independent investment management firm. After a review of various factors, such as your personal risk tolerance, investment timeframe, and investment objective, your financial consultant will present suitable investment managers for you to review and approve.

A Separately Managed Account has many benefits. In this article we will analyze how Separately Managed Accounts provide investors the highest level of diversification necessary to weather current market volatility.

The Overwhelming Challenge of Portfolio Diversification

One of the most important factors that determines the success an investor realizes is diversification.

The challenges that face an investor in actively diversifying their portfolio are overwhelming.

One aspect is the need to diversify across sectors. We are aware that companies that make up the investment universe are divided into sectors, such as Financials, Technology, Healthcare, Industrials, Consumer Discretionary, and so on.

Even within sectors there are sub-categories, such as within Financials there are retail banks, brokerage firms, mortgage companies, insurance companies, and so on. At any given time, as an example, investment advisors may be more bullish on banks and more bearish on insurance companies.

Drilling down further, some investment advisors view one retail bank as providing consistently solid returns while others do not. They may also be bullish on personal liability insurance companies while bearish on property and casualty insurance companies.

In order to maximize profits while reducing risk, each year there are recommended sector weightings, such as one year the recommended sector weighting is to have 17% of an investment portfolio in Financials, 12% in Technology, 9% in Healthcare, and so on. The following year the sector weighting in Financials may have risen to 19% while the Technology weighting recommendation may have dropped to 11%.

On an on-going basis as the value of an investment within a sector, or the sector overall, increases or decreases, the weighting should be reallocated.

Your financial consultant and brokerage firm would love for you to do that. It certainly is prudent, but if you are paying on a transactional basis, the only person that stands to gain anything at all is the financial consultant and brokerage firm.

Diversification Within Separately Managed Accounts

A Separately Managed Account may hold anywhere from 40 to 60 different investments, a risk-appropriate mix of equity and debt based on your investment objectives. You will receive a statement on a monthly or quarterly basis providing full transparency and outlining, for example, 34 shares of ABCDE stock, 16 shares of FG stock, 21 shares of HIJ stock, and so on. If you were to try and replicate what is accomplished in a Separately Managed Account, the transactional costs would inhibit any chance for profit.

As a Separately Managed Account is a fee-based service and not based on transactional commissions, the investment manager has the ability to reallocate on a frequent basis. It is not uncommon to see purchases and sales of investments made each and every day. Reallocation of investments adds to the diversification within Separately Managed Accounts.

Another invaluable provision of the diversification provided in Separately Managed Accounts is the access it provides to international investments. If you look around your house you will notice that your television is made in China, your kid’s XBOX is made in Hungary, your laptop is made in Indonesia, your car is made in Germany, and your cell phone is made in Singapore. Does it make any sense to you that your current financial consultant only provides access or insight for you to invest in U.S. companies?

A Separately Managed Account Sounds Expensive

The independent investment firm receives compensation by charging a percentage of the portfolio value on a quarterly basis. Though the percentage remains the same, the incentive to the independent investment firm is to grow your portfolio. The more your portfolio grows, the more money you each make. It’s a win/win scenario.

Remember that there are two sides to a stock in a traditional commission-based brokerage relationship. There is the commission paid to buy the stock, and there is the commission paid to sell the stock. The other constant in life is taxation. When you sell a stock the length of time you’ve held that stock will determine the capital gains (or loss) you may face.

A Separately Managed Account provides the added security of full transparency. You see on a quarterly basis the amount of money that is charged. You would likely flinch if you were to ask your commission-based financial consultant how much is being charged per trade.

The individual who utilizes a Separately Managed Account has access to an institutional level of investments and services typically reserved for large corporations and extremely affluent investors.