Here, Jerry Michael, president and co-founder of Smartleaf, which provides overlay portfolio management technology, gives an introduction to the technology and outlines why he views it as a tool for empowering brokers.

Empowering more brokers with discretionary authority is viewed as a daunting task.  It need not be.

Brokers-dealers have the opportunity to expand the pool of brokers authorized to take discretionary control of investment accounts, leapfrogging competitors – including those who are already fiduciaries – while ending up with greater efficiency than ever before. The transition is not technologically difficult. The key is overlay technology, which for a decade has enabled bank trusts and RIAs to increase scale, customization and consistency, while preserving local autonomy.

Combining control, customization & local autonomy

Moving to a “rep as portfolio manager” model while adhering to a fiduciary standard requires a workflow that can simultaneously combine control, customization and local autonomy:

Control:  Firms need to know that every portfolio is being managed in a manner consistent with the investor’s investment policy statement (IPS). This means ensuring that the allocation target is appropriate, that the portfolio is close to its target and that all constraints are being obeyed.  

Customization: A fiduciary standard requires customization. This includes tax management and risk management within the context of the client’s existing holdings. This needs to be delivered without compromising control.

Local autonomy: The broker is the person who knows the client best. Preserving his or her autonomy is not only consistent with broker traditions, it’s what’s best for the client.

These ostensibly competing goals can be achieved simultaneously - with overlay.

What is overlay?

Overlay is an approach to efficiently manage highly-customized individual portfolios. An overlay system uses three pieces of information to generate trade recommendations and rebalance each portfolio:

• The portfolio’s current holdings
• The target portfolio – a desired asset allocation formed by a blend of one or more models (lists of securities with weights assigned to them) customized to suit the unique needs of each client. An account’s target represents the investor’s ideal holdings, such as what the portfolio manager would purchase if investing with all cash and no constraints. An account’s target encapsulates both desired product selection and asset allocation.
• A client profile – an electronic IPS that reflects the preferences of the investor, the portfolio manager and the firm. This includes the assigned target portfolio, tax preferences, buy/sell/hold preferences and social screens associated with the account.

Overlay systems recommend trades that will move each account’s present holdings closer to their ideal portfolio (their target) in a tax- and expense-sensitive manner that respects the goals and restrictions of each investor. The portfolio holdings are where a broker’s clients are today, and the target portfolio represents where they would like to be. The client profile contains the parameters that govern whether and by how much the account can move from one state to another.

How overlay supports discretionary broker adoption of a fiduciary standard

In an overlay environment, firms can set bounds on target asset allocations and restrict model selection for each asset class to an approved list. This guarantees compliant targets. Portfolios are analyzed daily, so that any portfolio with excess drift or that is otherwise out of bounds will cause trades to be generated. Brokers can be given maximal discretion to provide customized service to the client, while management has the benefit of daily monitoring of all portfolios to ensure compliance with firm-specified bounds. This permits each discretionary broker to operate as suits their clients best, while every client is sure to get the benefit of the firm’s best thinking and guidance.

History repeating itself

This is not the first time that overlay has provided the answer to new pressures in the industry. Ten years ago, traditional private banks and trusts faced a challenge of transitioning to open architecture in a manner that preserved their ability to deliver customized solutions. Many firms had internal operations that were already stressed – lacking scale, consistency and control. Adding open architecture to the mix threatened to result in negative margins and operational breakdowns.

Forward-thinking firms turned to overlay to obtain open architecture while simultaneously improving scale, consistency and control. These firms turned a potentially difficult transition into an opportunity to rethink operations from the ground up.

The challenge facing broker-dealers is different, but the ability to use overlay to rethink operations is the same. It’s an opportunity to leapfrog competitors and improve operations - while providing superior service to clients as a fiduciary.