If Leonard Reinhart, president of Lockwood and one of the pioneers of the separately managed account industry, has his way, mutual funds may face a future sitting on the sidelines.

His vision: separately managed accounts will become the core of an investor's strategy, with other investments, such as mutual funds and real estate, in an ancillary role. Investors will use their SMA core investments to "communicate" with their other investments, shaping SMA holdings to balance and complement other, non-flexible products.

Among other things, this means that funds will be the investment product of choice for investors' smaller accounts or non-taxable assets -- hardly the choicest.

Sound bleak?

It very well may be, unless fund companies respond to the growing threat. If SMAs are able to capture the most profitable end of the market -- (Lockwood's "sweet spot" is accounts between $500,000 and $10 million, says Reinhart) -- fund firms will face perhaps their worst nightmare: many investors, with low account balances.

The biggest question remains: what's the best strategy for fund companies in these ever-changing times? While Vanguard and T. Rowe Price have decided to essentially become SMA providers (offering only proprietary portfolios), others are trying to figure out how to get their money managers on the larger platforms. The latter route poses additional problems: how to sell advisors on the portfolio?

Meanwhile, Reinhart is careful not to overhype SMAs: "I don't mean to say they're better than mutual funds…they're not." There are similarities between the two: both are liquid, diversified products, and they cost about the same, says Reinhart. But the key difference is that SMAs are customizable, whereas fund products "are what they are."

As people grow richer, they customize, in the same way that they might customize their home theatre systems. "It's all about customization…investing is no different," adds Reinhart.

Investors benefit from the customization in the way of taxes. While Reinhart estimates that mutual funds after-tax returns are 75 to 85 percent of total returns, he estimates that SMAs return in the 90 percent range. "If you save the client from writing a check to the IRS for $20,000…they're going to be your friend for three or four years," even if the account performs poorly, says Reinhart.

Case in point: Reinhart says November and December are the busiest months for Lockwood, citing tax loss harvest as the driver. He also says that certified public accountants are some of fastest to take to the idea of SMAs quickly.

Competitively, Reinhart compares Lockwood's positioning to the wirehouses favorably -- Lockwood doesn't have its own sales force, nor does it have proprietary products to cause conflicts of push. Lockwood relies on distributor-clients such as the Royal Bank of Canada and AXA Financial, two of its largest, says Reinhart. Law firms and CPAs are also among Lockwood's clients.

Currently, Lockwood offers 50 money managers investing in 115 styles, according to its website, and Lockwood's fees are 78 to 135 basis points.

In the long-run, Lockwood is working towards offering income-generating products for retiring baby boomers, says Reinhart. "We don't have enough income-based solutions for Boomers," he says. That strategy also implies that retirees' large rollovers will remain a holy grail for Lockwood, as well as other providers.

While Reinhart kept the lid sealed on what these boomer products might look like, he did point to hedge funds and partnerships as promising in some regards. But retirees are averse to the opacity and illiquidity of those investments, despite their income-generating attributes, says Reinhart.

In the short-term, Lockwood is continuing to add to its product array, looking to hedge funds-of-funds, commodities, and real estate. Also look for Lockwood and other SMA providers to continue moving towards a unified managed account model. 

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