Cumberland has utilized separately managed accounts (SMAs) to execute its fixed-income strategy since the company’s inception in 1973, long before SMAs were popularized in the early 2000s.
The reasons for managing money in this fashion are the same today as they were then:
- Transparency (You know what you own.)
- Flexibility to make strategic changes
- Ability to manage transaction costs and best execution
- Active management
SMAs offer individually catered portfolio management to address clients’ objectives, including tax management, income production, state-specific needs, cash flow-specific needs, and ability to institute investment restrictions. SMAs differ from pooled vehicles like mutual funds and ETFs in that each portfolio is unique to a single account.
Growth in SMAs: Federal Reserve Funds Flow Data
The advantages of SMAs have led to their increased use by investors. According to Citi Research, SMA municipal fixed-income assets, both taxable and tax-exempt, have grown from $100 billion in 2008 to $718 billion at the end of Q2 2023. Note in the charts below that SMA municipal and mutual fund assets have increased while direct retail has generally declined, although it increased in the most recent period. Technology improvements have also made it more efficient for managers to offer lower minimums for investing in fixed-income SMAs. At Cumberland our minimum is $250,000 and has been for some time. This size allows us to purchase enough bonds to provide diversification.
ETFs
Exchange-traded fund (ETF) volume has grown almost 50% since 2021 to $107 billion, and the number of funds grew to 81. Conversion of mutual funds to ETFs, as well as organic growth of ETFs, has contributed to the increase. Advantages of ETFs include intraday liquidity, low cost, diversification for smaller investors, and quick exposure to the asset class for larger managers. Given the losses experienced in the fixed-income markets compared with gains in the equity markets, many muni investors have conducted tax-loss selling. Some investors have chosen to move into ETFs as a placeholder in anticipation of bigger supply and higher rates, before reinvesting in individual bonds.
The amount of municipal assets under ETF management, at $108 billion, is still a small but growing 2.7% of the $4 trillion muni market.
Fund Flows
Mutual fund flows are affected by a herd mentality and thus present opportunities for active fixed-income management. Flows into and out of mutual funds can turn very quickly. When investors are dumping assets, the mutual fund portfolio manager may not be able to fully practice active management and must liquidate funds as required by redemptions. Retail, SMA, and other holders tend to be stickier.
The muni market has experienced mostly outflows from mutual funds since January of 2022, except for a spate of inflows. The week ended November 2nd, again saw outflows, at $1.5 billion. Many investors these days are investing in short-term funds or bank deposits yielding 5% and are cautious about moving into longer maturities, especially with the recent rhetoric of higher rates for longer! Now that the Fed has indicated it may end the hiking cycle, the tide could turn. The chart below shows that past cycles of outflows have occurred numerous times, and each time the recovery in rates has been quick.
Municipal Bond Credit Quality
Municipal bonds in general have higher ratings, less correlation to corporate bonds, and higher yields than other worldwide offerings do. Moody’s data show that many muni bonds are rated in the Aa category while corporate bond ratings are skewed to the lower ratings, including non-investment-grade and many in the Baa category. At Cumberland we invest in mostly taxable munis in our taxable fixed-income strategies, in addition to Treasurys, agencies, and some highly rated corporate bonds.
Efficiencies
At Cumberland we buy bonds in large lots and allocate positions to individual portfolios, a strategy which allows for better execution and pricing for our clients compared with doing individual trades for each client. When selling for individual-client money-raise requests, we use our extensive network of resources and knowledge of the markets and the particulars of a client’s portfolio to execute the most efficient sale.
Retail accounts do not enjoy the economies of scale that are available to an SMA manager. In addition, active SMA managers that practice total-return investing may have credit-research resources and relationships with many broker dealers that allow them to achieve competitive execution and develop strategies to optimize investment holdings to meet individual clients’ needs.
While mutual fund shares can be purchased and sold any day in any amount, an SMA account has many individual holdings that may take longer to sell. However, when an investor sells shares in a mutual fund, the price received is calculated at the end of the day, based on the net asset value of the fund. If an investor is instead invested in high-quality liquid bonds like the ones Cumberland purchases in its accounts, then, barring an extraordinary event in the market, there should be ample liquidity and the bonds could be sold at a time that maximizes price. Additionally, knowing our clients’ needs, Cumberland is looking ahead to provide liquidity when needed. SMAs can also give every client the advantage of providing the portfolio manager with sectors or categories to be excluded or included for a client’s desired impact, such as no tobacco-related securities or an emphasis on education or water quality. Customization is not possible with a mutual fund or an ETF.
Separately managed accounts generally have higher minimum investment requirements than mutual funds, ETFs, and robo advisors do; so they are not available to all investors. But as an investor acquires more assets and develops more highly tailored goals and objectives, an SMA may be appropriate.
Finally, the management fee charged on SMA accounts can be affected by the competitive environment. The fee is based on the type of strategy and can be scaled based on the level of assets invested. There may also be custodial fees charged to the account. Mutual funds have an expense ratio, which includes a management fee as well as miscellaneous ancillary expenses, custodial expenses, and a distribution charge. Many have various levels of sales charges. So, it is important to look at all expenses when comparing funds.
The Cumberland Approach
At Cumberland we have a top-down approach to investment management. We look at global macroeconomic conditions and policies to assess interest rates and growth prospects to position our portfolios accordingly. Each market and/or sector is evaluated as to how it fits into the global outlook as well as how its idiosyncratic elements may affect supply and credit quality.
The majority of our fixed-income portfolios are managed on a total-return basis using a barbell strategy to take advantage of changes in interest-rate and technical movements more quickly. The use of a barbell strategy allows us to invest in various short-term instruments that are liquid and to use them as ammunition to buy longer-dated bonds when interest rates rise or to take advantage of the higher coupons of longer-maturity bonds compared with shorter-dated bonds. Floating-rate notes and inflation-protected securities are investments that can help returns in the face of inflation and rising interest rates.
Returns of an account are measured against a benchmark, which is usually an index that is widely recognized. Outperformance may mean that individual portfolio returns are less negative than the benchmark’s or that positive returns are greater than the benchmark’s return.
Fixed-income total-return investing takes into consideration price appreciation or depreciation and the effects of coupon income generated and reinvested. Coupon payments over time are a large contributor to the return of an account, but the timing of buying and selling and the choice of where along the curve to buy or sell can greatly impact returns. Other buy-sell considerations include duration, or the sensitivity of a bond to changes in interest rates; embedded options such as call features; supply and demand; coupon structure; and credit-quality trends. All of these can affect the performance of a portfolio relative to an index or benchmark. Finally, to quote Cumberland’s John Mousseau, “Active management means active thinking, not always active trading.”
In summary, we continue to operate as Cumberland’s founders did, investing clients’ funds in separately managed accounts. Our approach to investing is top-down and takes account of global interest-rate expectations and credit-quality trends. Accounts are actively managed with a total-return or income orientation, depending on clients’ needs.
Patricia Healy, CFA
Senior Vice President of Research & Portfolio Manager
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