The growth in separately managed account portfolios has been dramatic over the last several years. SMA technology provider DeskTrading estimates that SMA assets grew by 85% between 2017 and 2020[1] and are projected to double from current levels by 2023.[2] But as technology permits SMA portfolios to be offered to investors with increasingly smaller asset bases, asset managers are faced with a quandary. How can they offer access to asset classes like niche fixed income, which is notoriously hard to diversify at smaller account sizes? How can they provide international equity exposure when SMAs are limited to buying American depositary receipts that represent only a small proportion of available opportunities?

Some asset managers have responded by launching completion funds—that is, no-fee mutual funds that fill gaps in SMA client portfolios. These funds enable asset managers to serve SMA clients across asset classes, increasing their ability to attract and retain SMA assets. However, they come at a cost. Creating an international equity completion fund vehicle could cost as much as $100,000 a year, and by design, it would generate little, or no, additional fees for the asset manager beyond the fee charged on assets for the entire SMA portfolio.

In this article, we look at the growth of completion funds in two critical areas of the market—municipal bonds and international equities—to provide insight on costs and opportunities in this market space.

Completion Fund Basics

Completion funds are a special form of mutual fund designed to complement SMA portfolios. These funds are filed and launched just like any mutual fund. They are used when it is difficult for investors to hold certain securities within their SMAs. For instance, fixed-income investors typically don’t have accounts large enough to diversify across all sectors with individual bond holdings. That’s particularly true in the municipal bond sector, where volatility has increased, putting a premium on active tactical management. Completion funds enable managers to apply flexible, tactical management strategies in their bond portfolios to add value around their long-term holdings. It is an easy way to increase diversification and flexibility to fixed-income strategies.

Regarding international equities, most SMA platforms only support investments in ADRs rather than foreign ordinaries. That presents a problem because not all foreign stocks are available as ADRs. Coverage is especially spotty in small- and mid-cap companies as well as emerging markets. Since completion funds can hold pooled ordinaries, they can provide diversification into areas of the market not accessible through ADRs. They can supplement the main SMA portfolio, where the investor has direct ownership of ADR securities.

Although completion funds have existed for more than a decade, their use has not been widespread. That said, as SMAs have become a greater focus, more asset managers are seeking to launch completion funds. Based on a FUSE Research Network survey of asset managers regarding their use of no-fee SMA (completion) funds, a third reported they are currently using the funds, while 12% indicated an interest in adding them over the next 12 months.

Filling a Gap in Fixed-Income Portfolios

Perhaps no other corner of the market has welcomed completion funds as warmly as tax-exempt fixed income. Trends in bond issuance, and particularly bond insurance, have forced a focus on active management and credit selection, which is challenging to execute in smaller portfolios.

Prior to the financial crisis, more than half (57%) of triple-A municipal borrowers carried insurance[3] to reduce their borrowing costs. As a result, it leveled the playing field and made credit analysis less important in muni fund management. However, the financial crisis decimated this coverage. By 2012, only approximately 5% of muni issuers carried insurance. Insurers have rebounded slightly, and more than 10% of muni issues were insured for the first time in a decade by 2020.[4] Even so, muni bond portfolio management remains far more active and tactical than ever before, and it is very difficult to take opportunistic positions in individual bonds within the context of a small to mid-sized SMA portfolio.

Asset managers have responded by establishing muni-focused completion funds. Among the top 15 intermediate municipal bond SMA strategies in the market, nine offer a completion fund, including three players dominating the category. JPMorgan leads with its $38 billion Intermediate Municipal Bond SMA, followed by BlackRock’s $30 billion Preferred Portfolio Management intermediate municipal SMA and Nuveen’s $19 billion Intermediate Term Municipal SMA.

In aggregate, we have identified 10 muni-focused completion funds holding $10.34 billion in assets, although the industry-wide total is likely higher. Since completion funds aren’t offered as standalone products, and therefore visibly marketed, they are difficult to identify.

For a more detailed view of how asset managers are using municipal bond completion funds, the following highlights two leading providers:

• PIMCO pioneered the use of completion funds in order for the firm to offer its flagship total-return strategy to SMA investors. Its muni bond managed accounts are constructed from two main components. A core SMA account representing 70% of these accounts, which holds a diversified portfolio of high-quality municipal bonds, and a smaller allocation to a commingled fund, which invests in specialized strategies. It is unclear if the municipal bond managed accounts strategy replicates a mutual fund, but the team, process, and philosophy are consistent with how PIMCO manages municipal bond mutual funds.
• Wells Fargo uses the same two-part structure but permits a slightly higher allocation to the opportunistic commingled fund. Wells Fargo CoreBuilder Municipal Income SMA uses a completion fund for nearly half of an investor’s allocation. Its SMA strategy is not a replication of a mutual fund, but rather a strategy developed for SMA investors.

Beyond municipals, taxable bond categories (particularly high-yield bond, corporate bond, short-term bond, and multi-sector) also each find a handful of managers utilizing no-fee SMA funds, although notably with no more than two funds in each category managing more than $1 billion in assets under management. 

International Equity SMAs: Solving the ADR Conundrum

International equity mandates are another area where completion funds have taken hold, primarily due to SMA restrictions on holding foreign-issued stock (foreign ordinaries). The majority of SMA providers (59%) offer international exposure solely through ADRs, while only 23% invest SMAs in both ADRs and foreign ordinaries. Since not all foreign securities have corresponding ADRs, this limits the investable universe considerably.

International equity completion funds are less common than fixed-income funds. While we can identify at least 25 major international equity SMA managers, only a handful currently offer completion funds, representing a tiny fraction of assets in this category.

Only four international equity SMA completion funds are currently in the market, with total assets of $1.6 billion—though as with muni bond completion funds, there may be others since these vehicles are somewhat difficult to find. Two of these funds, managed by Columbia Threadneedle and Fidelity, were launched in 2019, while two others (JPMorgan International Value SMA and BlackRock Managed Account Advantage Global SmallCap) were recently liquidated.

Two main factors limit international equity completion fund launches:

• Advisors seem reasonably satisfied with ADR strategies as a means for achieving international diversification. They are not clamoring as strongly for completion funds in this asset class, because, unlike in fixed income, they have workable options within the SMA platform.
• High, fixed costs have deterred some asset managers from offering these funds.

As a result, asset managers that run global or international strategies that cannot be replicated in an ADR-only portfolio must either turn away the opportunity to compete for model SMA business for these strategies or build a completion portfolio. The latter requires sufficient scale in the strategy to justify the expense.

Fund Board Considerations

Completion funds present fund boards with both familiarity and their own nuances. A fund’s launch is subject to board approval, and its operation will undergo familiar ongoing review. Yet, they are different from regular mutual funds in two key ways. First, they do not charge a management fee, and the adviser is waiving or reimbursing other expenses so that the total net expense ratio is generally at or close to zero (less than 5 basis points). In the approval of the investment advisory contract and other agreements, these factors should be given substantial consideration. Second, they are limited by prospectus to use within SMAs. 

Due to the limited peer universe for completion funds, the depth of fund reporting is typically determined at the board’s discretion. These funds are intended to be just one piece of a broader overall investment strategy and are available exclusively for use in SMA offerings. Because of these factors, the relevance of comparisons to the performance of traditional stand-alone funds may be limited. Because of this, in addition to reviewing information regarding the investment performance of the funds, boards should also review performance of the separate account composites that invest in the funds along with benchmark results for these composites. Given the explicit role within overall SMA offerings, the gauge of fund performance is less a matter of absolute or relative performance, but rather a matter of the fund fulfilling its role as a supporting component of the overall managed account. Finally, in terms of profitability, beyond the standard consideration with regard to the fund, this review should ideally take into account profitability estimates of associated separate accounts that invest in the fund.

Completion funds can be extremely useful to asset managers that serve the SMA market. They enable managers to provide niche, actively managed strategies that would be hard to execute in smaller SMA portfolios and to access assets such as foreign ordinary stocks that aren’t available via most SMA platforms. Yet these funds are expensive to maintain—and they generate little, or no, fee income. Fund Boards and their asset managers need to carefully balance the costs against their ability to provide a more holistic solution to advisors and their clients. Although not every asset manager needs to offer a completion fund, for some, a completion fund provides the missing piece in SMA portfolio management services.

Finally, a fund board being asked to approve any completion fund should not only be looking for answers related to the current opportunity, but also must look beyond today’s landscape. It will be expected the manager has determined there is enough demand among its SMA portfolios that the proposed completion fund itself will scale to a size justifying its start-up costs (not to be offset by any management fees). Stickier questions may be posed about the future: Is this completion fund a long-term solution? For example, what is the chance that further fintech enhancements will provide diversified fractional access to niche asset classes, negating the need for the ’40 Act product as a solution? Otherwise, completion funds have proven their merit over the last decade, for managers seeking that missing, and scalable, mutual fund piece to their SMA offerings.

Bob Kennedy is a consultant for FUSE Research Network, which provides data and consulting services to the investment management industry, including mutual fund boards. He is a contributor to the FUSE Benchmark Series and other FUSE research.