I am always amazed whenever I see a client statement from a major bank that still employs separate accounts for their stock portfolios. In the age of low-cost exchange-traded funds, these should be a dying breed. Nevertheless, they continue to be a major source of revenue for asset manager’s intent on hugging the benchmark.

Let me explain how these work….

Companies such as Merrill Lynch, UBS, Morgan Stanley and others love to thrust you into a basket of 75-100 stocks and charge an ongoing management fee for the privilege of their research and security selection. These are typically used by financial advisors and brokers who don’t understand how to construct a diversified portfolio.

So after you fill out the requisite investment questionnaire, you usually get the pitch on how this “large-cap value” account is perfect for your situation. Instead of buying the iShares Russell 1000 Value (IWD), which carries a 0.20% expense ratio, they are going to put you in a more concentrated portfolio of carefully selected equities.

Oh, and did I mention that will probably cost you in the neighborhood of 0.50% – 1.00% per year?

In addition to the fees, one of the reasons these separate accounts are beloved is they make the advisor look smart. I mean if you saw just one ETF in your account that had $200,000 invested in it, you would probably think that doesn’t look all that sturdy. But if you spread that money in $2,000 increments over 100 stocks, now they look really brilliant.

It’s also a way to make it hard to track the performance and beta of the strategy. The gains and losses for each individual stock within the portfolio are difficult to analyze on a regular basis. In addition, the fluctuations for the small position sizes don’t seem all that bad when they guess incorrectly and a few of them fall 20%. This is all a subterfuge to ensure you have no idea how your account is performing versus a benchmark.

Lastly, the separate account is designed to make it difficult for you to leave. I mean who wants to transfer that account out and pay $5-$10 transaction fees to liquidate all those positions?

I just did a quick screen and found 19 large-cap value ETFs currently trading today. IWD is the largest, but you can certainly replace that with the Schwab U.S. Large-Cap Value ETF (SCHV) for just 0.07% annually. The Vanguard Value ETF (VTV) is the second largest ETF in this space and charges an expense ratio of 0.09%.

The Bottom Line

If you find a separate account manager who has consistently beat their benchmark by 3-5% per year over 5 or 10 years, then certainly that strategy is worthy of your consideration. However, in the real world those are needles in the haystack.

Most investors are getting sold the equivalent of a high fee index mutual fund when they are put into these products. They rarely make a meaningful divergence in performance that is worth paying the added expense above a passively managed ETF. In addition, there are now many actively managed equity ETFs with reasonable expense ratios that may make for a suitable alternative.

Make sure you do your due diligence before putting your money in a separate account. The investing game is hard enough without having additional roadblocks of expenses, liquidity, or transparency in your way.