Begin with a simple concept: Every platform technology on the market today is based on some version of a Unified Managed Account Environment (‘UMA”) underpinned by the use of overlay technology to drive the internal workflows that create scale.

Ask ten different vendors to define UMA and you will get twelve different answers and the definitions will always define UMA in terms of the vendor’s proprietary offering. No surprise here. Unfortunately, there is a lot of confusion in the industry and much of it is the result of intentional misdirection by vendors. As a result, many institutions have gone in circles regarding their due diligence process.

Foundation level topics you need to understand before making an informed decision

Clarification on some common terms and discussion around UMA
For at least 10 years now, there has been a strong migration toward open architecture where providers of discretionary investment management services have sought to outsource some or all of their client’s portfolio allocations to top tier, third-party managers. Hence the term “open architecture” to describe open, disinterested election of a combination of proprietary and third party, managers that populate a client’s portfolio.

The industry’s first attempt to deploy third party managers in client’ portfolios was through Separately Managed Accounts (“SMA”) where individual client funds are allocated to third party investment managers by investment discipline and managed within sub accounts, outside the bank / Investment Adviser / Broker-Dealer. This complex system of dual books & records required an intermediary to report to the system of record for reconciliation and consolidation. In essence, there were always at least two sets of books and records: one primary and one “shadow.” The primary shortcomings of SMA, which eventually gave rise to the Unified Managed Account (UMA), was the high relative cost of third party managers in an SMA format, and the lack of coordination on behalf of an individual client with respect to duplication of effort, risk management, and tax consequences. As one of Winslow Capital Group, LLC’ institutional clients, said: “when using SMAs, we found that the diversification and alpha we were seeking was largely diluted by the added cost of the SMA managers and the additional complexity in workflow. We never achieved scale and consistency of product across our investment process as originally envisioned.”

Unified Managed Account environments (UMA) are the next iteration in the movement toward open architecture and another subset within the broad topic of open architecture. UMA is described as a process of portfolio synchronization using (overlay) software to coordinate and individualize the investment process by account objective, asset allocation and security selection with variable sensitivity to taxes, risk, and expenses across discrete, complementary investment disciplines… and to perform all of the reporting, investment management and trading, and operations support within one account. A unified process, if you will.

Overlay Software
Overlay software is the engine that drives the UMA process at the account level and across the entire universe of client accounts. It is a sophisticated technology that enables scalable and consistent application of the investment process by laying single or multiple investment disciplines over multiple accounts; each with different, individualized account objectives and investment guidelines and automates / coordinates / varies the sensitivity in security selection relative to tax, risk, and expenses.

Are rebalancing technologies the same as “overlay” and can they implement a UMA framework?
No, but in our experience most every simple rebalancing technology tries to position itself as an overlay technology that is suited to drive a UMA business model. Put differently, all overlay technologies offer basic rebalancing as a feature but not all rebalancing technologies are capable of delivering overlay. The difference between basic rebalancing technology and overlay lies primarily in the ability to link the rebalancing of a group of accounts with a “decision” process that assesses that trade-offs between minimizing portfolio costs as taxes, execution cost, and trading friction (such as bid:ask spread or execution costs) against a client specific set of investment constraints. The key component, however, is the ability to simultaneously customize and make decisions at the client level but implement in the aggregate, across an entire client base, at once. In short, true overlay technology delivers the oxymoron: “scalable customization.”

Types of Overlay
There are two important points to grasp regarding types of overlay:
  • Overlay is a business model not a product. It is not intended to and does not work as a product offering amongst many.
  • No two overlay vendors approach overlay the same way. There is no governing definition of what an overlay vendor should provide by way of features. Thus, different overlay vendors impart different manufacturing and distribution processes and these differences produce a different product and different business model based on the overlay technology elected.

Sub Account Overlay can include any type of security within one account through a process of assigning groups of securities to subaccounts within the UMA framework. This technique accomplishes the goal of keeping a client’s assets within one account but is complicated by the fact that a single portfolio manager cannot coordinate security selection at the client level because, where SMA managers are employed, no common portfolio management team is making decisions on behalf of any one client. That is, in subaccount overlay, there is versatility in the types of assets and managers that can be combined within one account but no coordinated management of the various disciplines and investment vehicles against an individual client’s investor policy statement.

There are some advantages in subaccount overlay in that it is easier to generate sleeve level performance for an individual investment style employed in the portfolio however, the topic of performance measurement and presentation presents a separate set of discussions that need to take place around the validity of assigning performance to a third party manager. In instances where less than 100% of a third party manager’s recommended trades are implemented, and the responsibility for time & price discretion is split between more than one individual, a meaningful and accurate measure of performance assignable to a particular third party manager becomes problematic. This is a deep topic that requires further discussion with each institutional client.

Model-Only, Overlay centralizes the securities in one account, like subaccount overlay, but also centralizes the intellectual capital of third party managers into the same account so that one (or one common group) of portfolio managers can coordinate all of the combined recommendations of the proprietary and third party managers against an individual client’s investor policy statement. The centralization of intellectual capital into one account framework and the ability to control the investment management process makes model-only, overlay the most scalable and lowest cost form of overlay. These features also make models-only, overlay the most disruptive technology for the same reasons.

In reading the foregoing, it becomes obvious that a more complete discussion about the impact of overlay, in general, on the business model including specific considerations and constraints of/on the technology, business model, and institution in question is required. There are several other variables involved in electing the right overlay technology including, who functions as the overlay portfolio manager, and where functionally and physically does this responsibility reside. Again, this is too dense a topic for a primer nonetheless, another critical decision impacting the open architecture business model.

Is Overlay the Same as Optimization?
In a word, no but this is a common misclassification of overlay. Optimizers are typically focused on balancing a given amount of risk (as defined by expected standard deviation) against an expected amount of return. Overlay is a technology best described and implemented as a portfolio management workflow and decision making tool. An overlay tool is principally targeted at scaling the investment manufacturing and distribution process through the ability to make customized decisions at the client level but implement on a mass basis, across many accounts simultaneously. Optimizers focus on risk management and the concept of scale only enters into the conversation as an unintended byproduct. Therefore, it is best to analyze optimization, and overlay as separate topics because they are separate goals with different outcomes.

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