Separate accounts

What Is Separate Accounts?

A separate account, also known as a separately managed account (SMA), is an investment portfolio owned directly by an individual investor and managed by a professional investment advisor. This structure falls under the broader category of investment vehicles and offers a high degree of customization, distinguishing it from pooled investment products like mutual funds or Exchange-Traded Funds. In a separate account, the client retains direct ownership of the underlying securities, such as stocks and bonds, rather than owning shares of a fund that in turn owns the securities. This direct ownership facilitates tailored investment strategy and specialized tax management.

Separate accounts are often utilized by high-net-worth individual investors and institutional investors seeking personalized portfolio management that aligns precisely with their unique financial goals, risk tolerance, and tax situation. The assets within a separate account are segregated from those of other clients and the investment firm, providing a clear and direct relationship between the investor and their holdings.

History and Origin

The concept of separate accounts gained prominence in the investment management industry during the 1970s. Prior to this, while direct stock ownership was common, professional management for highly customized portfolios was largely an exclusive service for the ultra-wealthy or large institutions. The development of separately managed accounts aimed to cater to clients who required specific objectives that did not fit the standardized structures of early pooled investment vehicles. This allowed for greater flexibility in managing individual portfolios, offering advantages like direct ownership of securities, customization, and objective investment advice for a set fee. Separately managed account.

Key Takeaways

Separate accounts are investment portfolios directly owned and managed for a single investor by a professional advisor.
They offer a high degree of customization in investment strategy, asset allocation, and tax management.
Unlike pooled funds, investors in separate accounts directly own the underlying securities.
Separate accounts can provide greater transparency and control over individual holdings.
Historically, they have been primarily accessible to high-net-worth and institutional clients due to higher minimum investment requirements and fees.

Formula and Calculation

There is no universal "formula" for a separate account itself, as it represents a legal and operational structure for managing investments rather than a single financial product with a calculable value based on an algorithm. However, the performance and fees associated with a separate account are calculated.

1. Performance Calculation: The performance reporting for a separate account typically uses the time-weighted rate of return (TWR) or money-weighted rate of return (MWR). The TWR is preferred for evaluating the investment manager's skill, as it neutralizes the impact of cash flows into or out of the account.

R_{TWR} = [(1 + R_1) \times (1 + R_2) \times \dots \times (1 + R_n)] - 1

Where:

(R_{TWR}) = Time-weighted rate of return
(R_n) = Return for sub-period (n) (calculated as (\frac{Ending\ Value - Beginning\ Value - Cash\ Flow}{Beginning\ Value + Cash\ Flow}))

2. Fee Calculation: Fees for separate accounts are often expressed as a percentage of assets under management (AUM) and can be calculated:

\text{Advisory Fee} = \text{AUM} \times \text{Fee Rate}

Where:

(\text{Advisory Fee}) = The amount charged by the investment advisor
(\text{AUM}) = Assets Under Management in the separate account
(\text{Fee Rate}) = The agreed-upon annual percentage (e.g., 1.00% or 0.75%)

This fee may be a "wrap fee" that covers investment advisory services, brokerage commissions, and custodial services, or it might be broken down into individual charges.

Interpreting the Separate Account

Interpreting a separate account involves understanding its bespoke nature. Unlike standardized pooled vehicles, a separate account's value and suitability are not solely determined by its absolute return, but by how well its management aligns with the investor's specific objectives and constraints. Key aspects of interpretation include:

Customization: A separate account is evaluated on its ability to implement a highly personalized investment approach. This means the portfolio's construction should directly reflect the client's individual needs, such as specific ethical screens, concentrated stock positions, or a desire to hold legacy assets.
Tax Efficiency: For taxable accounts, the effectiveness of tax implications strategies, like tax-loss harvesting, is a critical interpretive element. The ability to manage the cost basis of individual securities allows for greater control over capital gains and losses compared to pooled funds.
Transparency and Control: Investors in separate accounts benefit from direct ownership and clear visibility into every security held. This allows for a granular understanding of risk exposures and facilitates direct discussions with the investment advisor about specific holdings. The level of transparency is a significant advantage in evaluating the manager's actions.

Hypothetical Example

Consider Sarah, a high-net-worth individual, who has recently sold her business and has $2.5 million to invest. She approaches an investment advisor seeking a highly customized approach to her wealth.

Objective Setting: Sarah's primary objective is capital preservation with moderate growth. She also has a strong preference for socially responsible investing (SRI), specifically wanting to avoid companies involved in fossil fuels and tobacco. Due to a recent large capital gain, she is also highly focused on minimizing future tax implications.
Separate Account Setup: The advisor recommends a separate account. Instead of investing in SRI-themed mutual funds (which might not perfectly align with her specific exclusions), the advisor constructs a bespoke portfolio of individual stocks and bonds.
Customized Portfolio: The portfolio includes a mix of large-cap technology stocks, renewable energy companies, and government bonds, all screened to meet Sarah's SRI criteria. The advisor actively monitors the individual securities.
Tax-Loss Harvesting: In November, a few of Sarah's technology stocks experience a temporary dip. The advisor uses the flexibility of the separate account to sell these specific positions at a loss, offsetting some of Sarah's earlier capital gains, then repurchases similar, but not substantially identical, securities after the wash-sale period. This financial planning maneuver would be difficult or impossible in a pooled fund where an investor doesn't own the individual securities.
Ongoing Management: Sarah receives detailed statements showing every security she owns, its cost basis, and its performance. She can discuss any specific holding with her advisor at any time, illustrating the high degree of transparency and direct control offered by the separate account structure.

Practical Applications

Separate accounts are applied across various facets of the financial world, particularly where tailored portfolio management and direct ownership are paramount:

Wealth Management: High-net-worth individuals use separate accounts to achieve highly specific investment strategy goals, such as maintaining concentrated positions in legacy holdings, incorporating complex trust structures, or adhering to strict ethical investing guidelines.
Institutional Investing: Pension funds, endowments, and foundations frequently employ separate accounts to manage their large asset pools. This allows them to implement highly specific mandates, engage in direct private placements, and negotiate favorable fees directly with asset managers.
Tax Optimization: The direct ownership in a separate account enables advanced tax implications strategies like active tax-loss harvesting, specific lot identification, and controlling the timing of capital gains distributions, which are challenging in pooled investment vehicles.
Regulatory Compliance: Investment advisors managing separate accounts are subject to specific regulations, such as those under the Investment Advisers Act of 1940. This includes rules regarding custody of client assets and detailed record-keeping requirements by the Securities and Exchange Commission (SEC). Investment Company Registration and Regulation Package ³.
Customized Benchmarking: Unlike mutual funds that often track standard benchmarks, separate accounts can be benchmarked against custom indices or blends of indices that more accurately reflect the investor's unique asset allocation and investment strategy. This allows for a more precise evaluation of the investment advisor's performance relative to the client's specific objectives. Six Advantages of Separately Managed Accounts ².

Limitations and Criticisms

Despite their advantages, separate accounts have certain limitations and face criticisms:

Higher Minimums: Historically, separate accounts required substantial minimum investments, often $100,000 or more, making them inaccessible to many individual investors. While minimums have decreased in some offerings, they generally remain higher than those for mutual funds or ETFs.
Higher Fees: The personalized nature of separate accounts typically results in higher management fees compared to passively managed index funds or even many actively managed mutual funds. These fees can erode returns, especially over long periods. Research suggests that separate accounts may have much higher expenses than ETFs.¹.
Potential for Less Diversification: Depending on the account size and investment strategy, a separate account might hold fewer individual securities than a broadly diversified mutual fund or ETF, which could potentially expose the investor to higher company-specific risk if not managed carefully. Diversification is key to managing risk, and while a separate account allows for diversification, it does not guarantee it if the client or manager opts for a concentrated portfolio.
Complexity and Due Diligence: The personalized nature of separate accounts means less readily available public information for comparison compared to standardized funds. This places a greater burden of due diligence on the investor to thoroughly vet the investment advisor and understand the nuances of their management approach and fee structure.
Administrative Overhead: While the client doesn't manage the account day-to-day, setting up and maintaining a separate account can involve more paperwork and direct communication than simply buying shares of a fund.

Separate Accounts vs. Mutual Funds

Separate accounts and mutual funds are both popular investment vehicles that involve professional portfolio management, but they differ fundamentally in ownership structure, customization, and cost.

Feature	Separate Accounts	Mutual Funds
Ownership	Investor directly owns individual securities.	Investor owns shares of the fund, which then owns securities.
Customization	High; portfolio tailored to individual needs.	Low; standardized portfolio for all investors.
Transparency	High; direct view of all holdings and transactions.	Moderate; holdings reported periodically, not daily.
Tax Management	Excellent; allows for personalized tax-loss harvesting.	Limited; capital gains distributions shared by all investors.
Minimums	Typically higher (e.g., $50,000 - $250,000+).	Generally lower (e.g., $1,000 - $3,000+).
Fees	Often higher, typically a percentage of AUM (wrap fee).	Generally lower, expense ratio based on fund assets.
Investor Type	High-net-worth individuals, institutions.	Retail investors of all asset levels.

The key area of confusion often arises because both provide professional investment management. However, the direct ownership and customization offered by separate accounts stand in stark contrast to the pooled, standardized nature of mutual funds. This difference directly impacts tax efficiency, control, and accessibility for investors.

FAQs

What is the primary difference between a separate account and a mutual fund?

The main distinction is ownership. With a separate account, you directly own the individual stocks, bonds, or other securities in your portfolio. In a mutual fund, you own shares of the fund itself, which in turn holds a pool of securities.

Who typically uses separate accounts?

Separate accounts are most commonly used by high-net-worth individual investors, large families, and various institutional investors like pension funds, endowments, and foundations. They are ideal for those seeking highly customized investment strategy and specific tax management capabilities.

Can I customize my investment strategy with a separate account?

Yes, extensive customization is a core benefit of a separate account. You can work with your investment advisor to tailor the portfolio to your precise risk tolerance, financial goals, ethical preferences, and even specific legacy holdings you wish to retain or exclude.

Are separate accounts more tax-efficient?

For taxable accounts, separate accounts can be highly tax-efficient due to direct ownership. This allows for strategies like tax-loss harvesting on individual securities, specific lot selling, and greater control over the realization of capital gains, which is often not possible in pooled investment vehicles.

What are the typical fees for a separate account?

Fees for separate accounts are typically structured as a percentage of the assets under management (AUM), often referred to as a "wrap fee" that covers advisory services and trading costs. These fees can vary but are generally higher than the expense ratios of mutual funds or Exchange-Traded Funds, reflecting the personalized service and direct management.