Trust banks need more than outside investments to make their mark as true wealth managers. Kelly Thomas Coughlin is CEO of GlobalBridge, a Minneapolis-based third-party investment platform provider.

In the world of technology "open architecture" refers to technical specifications that are, could be, or should be in the public domain. This openness lets other manufacturers make products that are compliant with those specifications and, usually, compatible with one another.

In the realm of investing, however, "open architecture" has a narrower definition. It is generally used to describe access to third-party portfolio management. In that sense, "open architecture" provides an entrée to best-of-breed portfolio management versus limited, single-source "closed architecture" portfolio management.

That's a vital aspect of the advisory process, but it falls short of the flexibility that trust banks require to stay close to their customers and true to their cultures while enhancing their wealth-management capabilities. To redress that, the concept of open architecture must be broadened to include freedom of choice around custody, best execution, manager and vehicle choice and trust accounting integration. But to make this newly broadened concept a reality, third-party platform providers have to change their approach to the trust bank channel.

Best of breed

Intense competition for high-net-worth and middle-market institutional assets has convinced many financial intermediaries that they need best-of-breed managed accounts solutions featuring external as well as internal portfolio management. Sometimes this is a matter of countering a mistaken perception that they are not offering their clients best-of-breed solutions. At other times, however, that impression is not so far from the mark because of historical inferior performance of their internal portfolio management. Although wirehouse brokers initiated this trend, middle-market trust banks have come to see that internal portfolio management is, by and large, no match for the multi-manager investment platforms of the Wall Street brokerage houses.

In their efforts to become more formidable competitors, many trust banks have made two critical adjustments. First, they've formed true wealth management units whose aim is to match their clients' financial and personal goals with appropriate strategies and actions. That presents challenges, however. While a bank might embrace a competitive, wealth-management culture, it also doesn't want to lose its reputation as a safe haven for serious financial assets or come off as overly slick in the mold of a wirehouse firm.

Second, banks have begun to offer best-of-breed portfolio management. That can mean integrating their own internal, for example, large-cap or fixed income portfolio management with external small-cap and international strategies, or it can mean using 100% external portfolio management. Most banks are familiar with a best-of-breed approach through their use of mutual fund vehicles to fulfill certain assets classes called for in an allocation model.

But access to and best-of-breed in the managed account world is difficult - given the need for seamless integration with internal portfolio management, trust accounting connectivity and existing custody relationships. Some have chosen to build their own managed account program because they can't find a program that "flexes" to their trust bank requirements. This makes sense for some banks. Other than a speed-to-market risk, some would argue that a bank with over $10 billion in trust assets should build its own managed account program. But it isn't easy or inexpensive to build an open-architecture platform. The core functions that need to be resourced are:

Manager search, selection, due diligence, and monitoring
Proposal analysis, generation and consulting
Automated and efficient trading, portfolio management and construction; and
Efficient settlement and account reconciliation

The cost of building a managed account platform that performs these services effectively and efficiently is most likely too high for trust banks with less than $10 billion in trust assets. And of course there is more to running such a platform than assembling some outside managers and flicking an "on" switch. Manager due diligence and review should be continuous. In addition, the pace of product innovation can quickly make today's state-of-the-art platform seem old and inadequate to the demands of the marketplace.

To avoid such pitfalls, many financial institutions - small- and middle-market banks among them - have turned to third-party platform providers. These vendors - also called "turnkey asset-management programs" or "independent sponsor platforms" - can extend an institution's investment reach by making available strategies and vehicles that might have been unattainable otherwise. And they can do it for less than it would cost to build such a platform from the ground up.

But these platforms aren't always the best fit for banks, particularly for trust banks. At root, that's because many of these platforms were designed by and for broker-dealer type institutions, and many of these platforms cannot accommodate a trust bank's special requirements, among them the need for trust accounting integration and choice around custody.

It has to fit

The term "open architecture" must be broadened to include the following six components, which include best-of-breed portfolio management, in order for managed accounts to take the next crucial step to fully meet the needs of the trust bank market. We call this ACTIVE Open Architecture.

Access to portfolio management. Banks need ongoing access to best-of-breed portfolio management that gives the bank the opportunity to go head-to-head against wirehouse brokers and money-center banks. But, for the sake of quality, differentiation and transparency, it should not be the same roster of retail wrap portfolio managers that wirehouse brokers use. A broad and inclusive investment platform featuring outside managers is a good idea for several reasons. First, an approach that blends in-house thinking with ideas from the outside is more likely to meet a client's requirements than a narrower, all-proprietary approach. Second, it looks better: you're less apt to be viewed as a mere pusher of product. Finally, open investment architecture can spread a bank's performance risk across diverse managers, and so enhance its overall reputation as an advisory.
Custody that is neutral. The ability to use your existing custodian is very important. The alternative - re-papering client documents to move assets out of your bank to another custodian - simply isn't an option. A third-party platform operating in the trust channel should therefore be custody neutral and let the bank custody assets wherever it pleases. In part, that's a customer-service issue. Bank customers get enough in the way of paper sent their way. They don't want additional statements from custodians whose relationship with their accounts they don't necessarily grasp. Nor, frankly, do banks much relish the prospect of having to explain the ins and outs of custody to their customers. There is also a security imperative to open custody. A brokerage-style third-party platform commonly holds assets in what is known as "street name." Assets held in "street name" can be lent or shorted, so there is no guarantee that a customer's assets are actually in the broker's position at any given time. Assets held by a custodian in "nominee name," on the other hand, are always in the custodian's position.
Trading with institutional brokers. The ability to execute with any institutional broker on the street is desirable. Many programs funnel trading through their own affiliate broker-dealer or through a broker-dealer who custodies the program sponsors assets. Frequently, the best broker to execute a trade, commonly referred to as the "natural" broker, will not be the broker providing custody of the assets. ECN brokers have acquired over 30% market share over the past decade. These brokers trade for pennies a share. Other more traditional brokers provide best execution services for securities that are harder to trade, such as small-cap stocks, American depositary receipts, or municipal bonds. Having the flexibility to trade with the best executing broker for any given trade is very important. However, that doesn't necessarily mean that is where you, the client, will want to trade. Perhaps you have a directed brokerage arrangement with a broker and you want all or a percentage of those trades routed to that broker. Your providers must have the flexibility to accommodate your needs.
Interface with trust accounting system. Delivering transaction and position information to the bank's existing trust accounting provider and extracting transaction and position information from the existing trust accounting provider is critical. This calls for an automated straight-through-processing standard of trade input and an automated extract of transactions and positions from the trust accounting system to the portfolio management system.
Vehicle of choice. A managed account program must offer more than just traditional stocks and bonds. While most consultants and experts in financial services agree that using the managed account product structure is the best product for high-net-worth and institutional assets above $1 million, frequently it is prudent and appropriate to fulfill an asset allocation model in part with a mutual fund and or an exchange-traded fund. It is vital to work with a managed account program that allows flexibility to use multiple vehicles and doesn't force you to accept its pick of manager of the moment.
Expense management. A managed account program can offer more than the traditional static expense pricing that a traditional mutual fund format offers to the client. The advantage is that the trust bank employee has the opportunity to discuss openly the pricing of various products and the favorable pricing model of the managed account. Additionally, managed accounts have an actual transparent monetary cash payment for fees, while mutual funds have a somewhat hidden "expense ratio" deduction from fund share price NAV. This clarity and transparency is appealing to those banks seeking to communicate true expenses to their clients and manage and control such expenses.

The overall point is that the buyer - here, the trust bank - should dictate the specifications around which a managed account provider delivers its services. The extent to which managed account providers conform to these ACTIVE standards by delivering choice around portfolio management, custody, trading, trust accounting, investment vehicles and expense management is the true measure of "open architecture."

Absent this broader, more inclusive definition, the term is mere verbiage, a buzz phrase coined to mask the inadequacies of a one-size-fits-all approach to the trust bank channel. -FWR

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