Mass Customization Has Finally Arrived

The Price Wasn't Right Financial-services companies have long assured the unwashed that they, too, can invest like the wealthy. Own a portfolio built only for them, considering their individual needs. Get off that bus! Hop into a Lincoln Town Car, sink into the black leather, and go where you like.

Such has been the claim for separately managed accounts (SMAs). Invented in the 1970s and popularized in the 1990s, SMAs promise customization for those with modest assets. True, SMA investors are initially placed into a model portfolio that is the same as everybody else's, but from there they can adjust according to their desires--at no extra charge, as all services are included in the annual fee.

The problem has been the cost of delivery.

Traditionally, SMA investors customized their portfolios through discussions with their full-service financial advisors. That process is expensive. A client who calls for a modest 15 minutes each month, and who has an annual hourly sit-down review, will consume four hours' worth of an advisor's time per year. There's no way to make that work for a $50,000 or $100,000 account. Either the advisor accepts lousy pay, or the investor gets little customization.

In addition, tinkering with portfolios complicated the tasks of the active managers who, traditionally, were hired to run SMA assets. A 2007 study found that some investment managers refused to accept SMA mandates that were accompanied by "client-specific constraints" (which very much begged the question: how can an SMA not have client-specific constraints?).

The result, wrote a financial planner during SMAs' heyday: "Managed accounts for 'modest' net worth clients are truly cookie cutter with very little customization."

The fees have been no bargain, either. The 2007 study found an average annual cost of 2.00% for lower-end investors, with overall SMA fees at 1.65%, because of volume discounts given to the wealthier customers. Things haven't much changed; the first SMA price to pop up on my Google search was 2.50% on equities, 1.25% on fixed income, for a $100,000 account. That's a whole lot of money to spend on limited customization.

In short, SMAs have failed the mass-market investor. They have offered too much touch, too little technology. The product was built with the full-service customer in mind--and that customer, if holding only a modest amount of assets, cannot receive such a service at a competitive cost. The math fails.

(To SMA providers who are unamused: I quarrel not with your offering. For wealthy investors, the SMA can be a good deal for both the buyer and seller. A large asset base makes possible the happy compromise by which the buyer receives a substantial price discount, thereby making the percentage fee acceptably low, while the seller receives substantial actual dollars, thereby making the business profitable. Win-win.)

Low Touch, High Tech The new breed of automated advice is filling the void. By "new breed" I mean any service that, through a combination of a website and scalable telephone support (that is, where the phones are answered by lower-cost, easily trained employees), delivers some level of customization to mass-market investors at an annual, all-in fee of 0.50% or less. The service may or may not bill itself as a "robo advice." The label matters not. What counts is if the service is customized and is delivered cheaply to the masses.

That is starting to happen.

Many of the early automated services were either priced too high or were not truly customized, coming in only a handful of sizes. As demonstrated by target-date funds, the latter is not necessarily a severe investment problem; most investors, particularly at lower asset levels, can do just fine with an off-the-rack solution. It is, however, unacceptable if the goal is mass customization.

But the offerings are improving. One example: Wealthfront's Tax-Optimized Direct Investing. For an annual all-in cost of 30 basis points, Wealthfront will create a portfolio that consists of 100 large-company U.S. stocks, plus two exchange-traded funds, one that gives small-company U.S. exposure, the other delivering international exposure.

The initial Wealthfront investment is not customized. It consists of three indexed portions, the same for all. However, the ongoing management is investor-specific, as for tax purposes Wealthfront sells the losers among the 100 directly held stocks, and retains the winners. This "harvesting" generates tax losses that can be used to offset gains that occur elsewhere in an investor's portfolio. In that sense, the service offers a tax advantage over even the most tax-efficient funds (whether mutual or ETF)--and it is fully customized, at the individual level.

(Whether the service is as whiz-bang as Wealthfront claims is another matter, to be discussed next week. Suffice it to say that the eye-popping benefits associated with tax-loss harvesting that Wealthfront cites in its research, ranging up to 2% per year, come with several asterisks. But with a price tag of 30 basis points, the service doesn't have to be fantastic to be a great deal. Pretty good would get the job done.)

Happy Days Let me be clear: Customization is an overrated virtue. Most people, in most circumstances, can--and should--take the bus. Wealthfront's service, for example, only makes sense for taxable accounts, with people who have enough money to hold additional taxable assets besides the minimum of $100,000 that they give to Wealthfront. Inevitably, other flavors of customization are either for vanity, or are useful and applicable only in certain situations.

However, an overrated virtue is nonetheless a virtue. There are times when individual situations can and should be reflected in the portfolio. That companies are learning how to do this cost-effectively for typical investors is a boon. For mass customization, the good old days are now.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.