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Is snob appeal selling separate accounts?

Wall Street has a hot new product. Never mind that it has been around for 30 years. Long reserved for the very rich, separate accounts are being dusted off and dressed up as the investment du jour for clients with a mere $100,000 to spare. There's no question that the Street is marketing them aggressively to shore up its shrinking asset-management business. What's less certain is whether these often-expensive products can deliver what disgruntled investors, reeling from a two-year bear market in stocks, are being promised.

Separate accounts allow investors to choose from a wide range of off-the-shelf stock and bond portfolios and tweak them to suit their personal whims and tolerance for risk. Unlike mutual-fund investments, buyers own the securities directly, so they have complete control over when they harvest capital gain or loss distributions, enhancing their aftertax returns. It's all neatly packaged for an annual flat fee of up to 3% of the portfolio's value. There's no extra charge for trading costs or investment advice.

That's the sales pitch. But for all the benefits the providers are touting, separate accounts aren't everything they're cracked up to be. A recent report on the industry from Cerulli Associates, a financial-services research firm, found that a mere 15% of all separate accounts are actively customized with individual stocks chosen by their investors. And only a third of all taxable accounts get the specialized tax treatment that almost every program promises.

Worse yet, it's almost impossible to comparison-shop among separate-account managers because the industry lacks performance ratings. "They're being oversold as a result--and in the process, sowing the seeds of their own destruction," says John W. Eckel, a planner with Pinnacle Investment Management Inc. in Simsbury, Conn.

That's not stopping banks, brokerages, and the like from falling all over themselves to get in on the action. Many are beefing up their sales staffs. Dreyfus Corp. more than tripled, to 14, its number of separate-account marketers, a special breed of sales rep, in January. Others, like Morgan Stanley Dean Witter & Co. (MWD ), are paying their brokers higher commissions to sell the accounts. And mutual-fund companies such as AIM Funds and MFS Investment Management are building the business from scratch to stanch the flight of investors from their traditional funds.

Providers are trolling for hot prospects among baby boomers, who are set to inherit far more wealth from their parents than any previous generation, as well as job-hoppers and retirees, whose huge retirement savings can be rolled over into new accounts. The strategy is paying off big: Separate-account sales are outpacing those of hedge funds, mutual funds, and standard brokerage accounts. Boston's Financial Research Corp. says that separate-account assets are expected to grow 20% a year, to $1 trillion in 2005, having already quadrupled since the mid-1990s.

There are ways to fix some of the shortcomings of separate accounts--but it won't be easy. Both Morningstar Inc. and Standard & Poor's (which, like BusinessWeek, is owned by The McGraw-Hill Companies) are working on a rating system. But because each investor portfolio is different, direct comparisons aren't cut and dry. The Money Management Institute, the trade group for the separate-account industry, thinks the effort is nearly impossible. "There's not much utility in digesting all of that information into some kind of simple star system," sniffs Christopher L. Davis, executive director.

Mutual-fund managers running separate accounts will have to get used to heightened scrutiny. Their stock holdings in mutual funds are published quarterly at most, and are almost never up for discussion. "Now the world will see their portfolio daily, and they are afraid it will give the investor and adviser the opportunity to question them," says Paul D. Schaeffer, executive vice-president with Capital Resource Advisors, a Chicago consultant to the financial-services industry. What's more, most managers focus on total returns, keeping turnover and expenses low. That's not what you want in your separate-account manager, says Len Reinhart, chairman of Lockwood Financial Group, which recommends 55 managers and 120 investment styles for its separate-account business. "Some of our best aftertax managers are high-turnover because they are constantly harvesting losses, selling and buying stocks," he says.

Many new entrants will be tripped up by the complex computer systems required to run separate accounts. Keeping tabs on thousands of individual accounts is also labor intensive, so it's hard to scale up back-office operations fast enough to keep pace with booming business, Cerulli reports. "Administratively, it's a tough product," says Reinhart, who worries that the industry will buckle under the weight of its explosive growth. "It's grown, to date, by people jury-rigging systems. It can't continue to go that way."

Plus, mutual-fund companies don't specialize in providing financial advice. The advice component could also backfire: "Many who will get into this business will fail," says Jim Norris, director of strategic planning at Vanguard Group Inc. "Just because you have some wealthy investors doesn't mean you're in the high-net-worth business."

The ever-resourceful money-management industry appears to have struck a rich vein with separate accounts, even though "it seems to be more marketing and snob appeal than anything else," says Bryan Olson, director of the Charles Schwab & Co. Center for Investment Research. If so, investors may just be rushing after fool's gold.

By Mara Der Hovanesian in New York

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