What Is a Separate Account?
A separate account, also known as a separately managed account (SMA), is an investment portfolio owned directly by an individual investor or institution and managed by a professional investment management firm. Unlike pooled investment vehicles such as mutual funds or exchange-traded funds (ETFs) where investors own shares of a fund that in turn owns the underlying securities, a separate account grants the client direct ownership of the securities within their portfolio. This approach falls under the broader financial category of portfolio management, offering a high degree of customization to align with specific investment goals, risk tolerance, and tax considerations.
History and Origin
The concept of professionally managed individual portfolios has existed for a long time, particularly for very wealthy individual investors and institutional investors. However, the widespread popularity of separately managed accounts began to grow significantly in the mid-1970s. In 1974, E.F. Hutton notably pioneered the concept by introducing "consulting services accounts" to retail clients. This move aimed to address specific client objectives that were not adequately met by the more restrictive structures of mutual funds prevalent at the time. The evolution of separate accounts has been driven by the desire for greater transparency, direct ownership of assets, and the ability to tailor investment strategies to individual needs.
Key Takeaways
- A separate account is a personalized investment portfolio managed by a professional firm where the client directly owns the underlying securities.
- It offers significant customization for investment strategies, tax management, and adherence to specific client preferences.
- Separate accounts differ from pooled vehicles like mutual funds and ETFs, which combine investor assets.
- They typically have higher minimum investment requirements compared to mutual funds and may involve a "wrap fee" that covers various services.
- Regulatory oversight, such as the SEC's Rule 3a-4, helps define and regulate these individualized investment programs.
Interpreting the Separate Account
A separate account is interpreted as a highly personalized investment solution. Its value is directly tied to the performance of the underlying securities, which are held in the client's name. Unlike a mutual fund where investors receive a net asset value (NAV) per share, a separate account holder observes the actual prices and quantities of each security owned. The manager of a separate account operates with discretionary authority, meaning they can make investment decisions on behalf of the client without seeking approval for each trade, provided these decisions adhere to the client's pre-defined asset allocation and investment policy statement. The interpretation of a separate account's effectiveness largely revolves around its ability to meet specific client objectives, manage taxes efficiently, and provide a tailored investment experience that pooled vehicles cannot offer. Investors often evaluate the performance of a separate account based on its net returns after fees, considering its specific fee structure and tax implications.
Hypothetical Example
Consider Jane, a high-net-worth individual who recently sold a business, resulting in a significant capital gains tax liability and a desire for highly specific investment control. She approaches a financial advisor seeking a personalized solution.
Instead of investing in a broad mutual fund, Jane decides to open a separate account with an investment management firm. Her advisor helps her define an investment policy statement that outlines her goals: long-term growth, a specific focus on environmentally friendly companies, and a desire to exclude tobacco and firearm manufacturers from her portfolio. The advisor also notes Jane's substantial unrealized gains from her previous business sale, indicating a need for active tax management, including tax-loss harvesting.
The firm then constructs a portfolio of individual stocks and bonds, directly held in Jane's name, that aligns with her ESG (Environmental, Social, and Governance) preferences. Throughout the year, if a security in her portfolio experiences a loss, the manager can sell it to offset gains elsewhere, thereby minimizing Jane's taxable income. This level of individualized attention to both her ethical investing preferences and tax situation would be impractical, if not impossible, in a commingled fund structure. Jane receives regular performance reporting that details the exact holdings and transactions in her account.
Practical Applications
Separate accounts are utilized in various facets of financial planning and investment management. For high-net-worth individuals, they enable tailored portfolios that can incorporate specific tax strategies, such as tax-loss harvesting, or accommodate unique liquidity needs. Institutional investors, including pension funds, endowments, and foundations, frequently use separate accounts to manage large pools of capital with precise investment guidelines and mandates. This allows for greater control over asset selection and risk management compared to investing in commingled funds.
Moreover, separate accounts are essential for complying with specific regulatory requirements. For instance, the U.S. Securities and Exchange Commission (SEC) adopted Rule 3a-4 under the Investment Company Act of 1940 to provide a non-exclusive safe harbor for certain investment advisory programs, including many separate accounts, from being classified as unregistered investment companies. This rule ensures that clients in such programs receive individualized treatment and retain direct ownership, distinguishing them from traditional pooled investment vehicles. The Alternative Investment Management Association also highlights how separate accounts have become a preferred method for institutional investors to deploy capital due to their customization, transparency, and control.
Limitations and Criticisms
While separate accounts offer significant advantages, they also come with certain limitations and criticisms. One primary concern is the higher cost structure compared to pooled investment vehicles. According to data cited by Cerulli Associates, the average fees for separate accounts can be notably higher than those for mutual funds or ETFs, often encompassing both an advisory fee and an asset management fee. These costs can erode returns, especially for smaller account sizes.
Another potential drawback is the typically higher minimum investment required to open a separate account, which historically limited their accessibility to only the wealthiest investors. While minimums have decreased over time due to technological advancements, they generally remain significantly higher than those for mutual funds or ETFs, making them less suitable for individuals with limited capital. Additionally, despite offering customization, a separate account might inherently provide less broad diversification compared to a mutual fund that holds hundreds or thousands of different securities across various sectors and geographies. The concentrated nature of a highly customized separate account could potentially expose an investor to greater specific risks if not properly managed or if the account size limits the number of individual holdings.
Separate Account vs. Mutual Fund
The fundamental distinction between a separate account and a mutual fund lies in asset ownership and customization.
| Feature | Separate Account | Mutual Fund |
|---|---|---|
| Asset Ownership | Client directly owns individual securities. | Client owns shares of the fund, which owns the securities. |
| Customization | High degree of personalization for goals, taxes, ethics. | Limited to the fund's stated investment objectives. |
| Transparency | Full transparency of underlying holdings and trades. | Holdings disclosed periodically (e.g., monthly, quarterly). |
| Minimum Investment | Typically higher (e.g., $50,000 to $250,000+). | Generally lower (e.g., $0 to a few thousand dollars). |
| Fees | Often includes a "wrap fee" covering advisory and trading costs. | Expense ratio, which covers management and operating costs. |
| Tax Management | Active tax-loss harvesting and specific gain/loss management possible. | Tax events are determined by the fund manager and shared by all investors. |
The main point of confusion often arises because both are professionally managed investment vehicles. However, a mutual fund pools money from many investors to create a diversified portfolio, with each investor owning a pro-rata share of that pooled portfolio. In contrast, a separate account is a distinct portfolio dedicated solely to one investor's assets, allowing for tailored strategies and direct control, even though the day-to-day trading decisions are typically delegated to a professional manager with a fiduciary duty.
FAQs
Q1: Who is a separate account best suited for?
A separate account is generally best suited for individual investors or institutional investors with significant assets who seek a high degree of customization in their portfolio. This includes those with specific tax considerations, ethical investment preferences, or unique liquidity needs that cannot be met by pooled investment vehicles.
Q2: Can I choose the individual stocks and bonds in my separate account?
While the portfolio is managed on your behalf by a professional firm, you typically have the ability to set specific guidelines and restrictions for the separate account. This can include excluding certain industries or companies, or focusing on specific sectors, but the day-to-day selection of individual securities is usually left to the discretion of the professional portfolio management team.
Q3: How are fees typically charged for a separate account?
Fees for a separate account are often structured as a "wrap fee," which is a single percentage of assets under management (AUM) that covers investment advisory services, trading commissions, and sometimes custodial fees. This differs from mutual funds, which charge an expense ratio. The specific fee structure can vary depending on the firm and the complexity of the strategy.