Mutual funds vs. private money managers

Have future topics for the Mole to address? E-mail him at themole@moneymail.com.

Ultimate Guide to Retirement

• Getting started
• 401(k)s & company plans
• Investing
• Annuities
• IRAs
• Self-employment plans
• Pensions and benefit plans
• Social Security
• Insurance
• Estate planning
• Living in retirement
• Getting help

More from Money Magazine

Put Santa's elves on a budget Squandering a minor's trust fund Weaker dollar, stronger returns

Best Places to Live Current Issue Subscribe to Money

NEW YORK (Money) -- Question: What is your opinion of brokerage-managed accounts? Are these separately-managed accounts a good way to have your money managed?

The Mole's Answer: The pitch goes something like this:

"90% of mutual funds will underperform the market and these retail funds are for common investors. We have access to thousands of private money managers and only select those from the top 10%. If they fail to perform in the top quartile, we fire them and move your funds to a better manager. These are normally for our institutional investors but we have a platform that can get you in for as little as $100,000."

Unlike mutual funds, these separately-managed accounts use private money managers to pick individual stocks for you of which you actually own the shares. For example, a brokerage firm could pick a few different managers for various asset types such as large-cap stocks, small-cap stocks, international stocks, bonds, REITs and alternative asset classes. The money managers all seem to promote two things - above market performance and extreme tax-efficiency by making fewer trades.

These categories of managed accounts were once reserved for wealthy investors with tens of millions of dollars, but wily Wall Street has now found a way to make money from smaller investors as well. The way it works is that the investor is charged something like 1.5% in total fees with some going to the brokerage firm and some going to the individual money managers. Your adviser then carves up your portfolio giving specified amounts to each of several money managers.

Mutual funds vs. separately-managed accounts

There are certainly some key differences between retail mutual funds and separately-managed accounts. As mentioned, you actually own the underlying securities with these accounts rather than shares of a fund that owns the securities. Thus, if you don't like the manager any more, you can often leave and just take the securities with you.

Another difference is that separately-managed accounts don't have the dismal track record that active mutual funds have. Unfortunately, this is because they have no track record at all. They don't have to report their results like mutual funds do.

In my view, though, separately-managed accounts have far more in common with active mutual funds than the mainly minor differences. They both pay expert managers a lot of money to try to outsmart other expert managers. And in spite of touting tax-efficiency, I typically see managed accounts trading often and needlessly passing through capital gains to the investor.

The concept of snagging the best private money managers only to fire them if performance isn't stellar is remarkably similar to buying one hot mutual fund and then moving to another hot fund when your original fund underperforms. It's nothing more than performance chasing using a slightly different vehicle, but providing the same buy-high-and-sell-low results.

Whether I'm reviewing a new client's portfolio of stocks, mutual funds, or separately-managed accounts, I consistently see more risk and lower returns than just owning the entire market.

My advice: I always recommend a broad portfolio that owns the entire global market with costs as low as possible. There are some good reasons to hire a financial planner but beating the market isn't one of them. Ask any prospective adviser some tough questions.

I advise staying away from advisers who use separately-managed accounts every bit as much as avoiding advisers who pick individual stocks or active mutual funds. It may seem logical but, in reality, you end up making a bet that few will win in the long run.

The Mole is a certified financial planner and certified public accountant who - in the interest of fairness - thinks you should know what goes on behind the scenes in financial planning. Want to make contact? E-mail mailto:themole@moneymail.com.