Smartleaf has released its second white paper in a series aimed at increasing understanding about the effects of implementing overlay technology for wealth managers.

The white paper, How Overlay Changes Your Workflow, discusses the way a models-based approach to managing investments changes the daily operations of a wealth management firm.

Jerry Michael, president of Smartleaf, told Family Wealth Report that one of the most interesting aspects of the technology is that it gives firms the choice to separate out the roles of investment guidance, security selection, customization of customer accounts and rebalancing. However, it is a choice, not a necessity, and the roles can remain divided as before.

“There are these options, and as a first roll-out, firms will probably choose the option that is the least change,” says Michael. “Only slowly are people testing the limits of what this approach can do. These things take place incrementally,” he adds.

This is often the way with new technology adoption, says Michael. The overlay industry, along with other innovations in recent years such as the rise of exchange-traded funds, could be characterized as part of a movement that is challenging traditional wealth management models.

However, as Michael has pointed out previously, in many ways overlay is a return  to tradition – in that it allows for the possibility of relationship managers taking on more control of their clients' portfolios.

Smartleaf’s paper lays out the various workflows that overlay provides for and how this affects roles within a wealth management firm – an issue the firm is aiming to spread awareness about.

One role the technology most affects is that of portfolio manager. Because guidelines on asset allocation and security selection can be entered directly into the system, rather than communicated at firm level, portfolio managers can spend less time on implementation and more time on deciding investment policy.

They are, essentially, repositioned as “thought leaders” within a firm, Michael explains. He says that this appeals to firms as it allows a best-of-breed approach to be applied to asset management, and means all their clients receive the benefit of each portfolio manager’s expertise.

However, firms will take different routes depending on their focus, as overlay allows for completely proprietary models on the asset management side through to fully open architecture, via the use of models. Most often, though, he sees firms using a hybrid approach that combines their internal portfolio managers and models bought elsewhere.

Of course, for some wealth managers, the technology won’t make sense. It is geared towards allowing for more tax management, towards making the asset management process more systematized to an extent, and therefore to allowing more time for customer relationships and business development.

“There are some asset managers out there whose value is that they’re extremely good at trading,” says Michael, “that sort of asset management does not lend itself to overlay.”

Wealth managers who have extremely high portfolio turnover rates and who focus almost exclusively on providing alpha in that way would be unlikely to use overlay.

Cheaper alternatives to mutual funds

In terms of the wider landscape for portfolio management, innovations on both the product and technology side have been putting pressure on fees in recent years. For example, the ETF industry has been growing quickly, indicating investor appetite for cheaper, more transparent products when it comes to liquid securities. Michael does not see this as a rival portfolio management model to overlay technology though, as overlay can be used to manage ETF portfolios.

However, he believes that in some ways overlay undermines the need for active ETFs, which were hotly tipped in a report by SEI this week as potentially providing the next growth boom in the exchange-traded industry.

“While it’s relatively inexpensive to create an ETF, it’s even less expensive to create a new model,” says Michael.

“As flexible as ETFs are, I think overlay will always be more flexible,” he says, and they are also tax-efficient down to the level of the individual security.