Sleeves destroy value by lowering risk-adjusted after-tax returns. They also increase operational complexity and cost.
Go Sleeveless or Go Home
In models-based portfolio management, sleeves (a.k.a., sub-accounts, silos, or partitions) increase costs and lower risk-adjusted expected after-tax returns.
We can’t claim to be neutral here – Smartleaf is, after all, a leader in sleeveless (holistic) portfolio management – but if you bear with us, we think you’ll find this useful. So, roll up your sleeves (as it were), and let’s get started.
What Are Sleeves?
A sleeve is a virtual sub-account, a portion of a portfolio that can be traded separately.
Sleeves are useful if you wish to sub-contract the trading of a portfolio to multiple asset class specialists, which can make sense if the securities traded are illiquid (think fixed income, alts, and derivatives) or trading is central to the strategy itself (think high-frequency market makers).
But, as we will see, sleeves get in the way of implementing a models-based program.
Why sleeves are bad when managing at the account level.
Sleeves destroy value by lowering risk-adjusted after-tax returns. They also increase operational complexity and cost.
Operational complexity and cost
Sleeves require extra machinery and processes.
Some of these are the vendor’s problem (though they’ll likely pass on the cost). But some of them are yours.
First, the stuff that is, hopefully, the vendor’s problem: sleeves require a “shadow” accounting system that keeps records of the holdings of each sleeve, together with a reconciliation process to make sure that holdings in each sleeve, when combined, equal the holdings of the actual portfolio.
Optimal tax-lot selection for sales requires some mechanism for swapping tax lots between sleeves so that any given sale can be made with the best tax lot available. And to avoid simultaneously buying and selling the same security across two different sleeves, you’ll need some sort of cross-selling matching process.
Second, the stuff that makes your job more tedious: Sleeves require a separate process for transferring funds between sleeves. Usually, this requires selling the assets in one sleeve and buying them in another, which may generate a large amount of trading and realized gains. Advisors try to avoid this, so it’s not an automated step. And that means that asset-class rebalancing (or any other event where you transfer funds between sleeves) requires manual review.
Sleeves also make cash management harder. Every account will generate its cash level from distributions. This complicates the task of funding withdrawals, paying fees, and preventing overdrafts. Either the cash in every sleeve is systematically siphoned off in separate transfers to a sweep account, or every account maintains its own cash balance level. Theoretically, the vendor could handle much of this, but it’s not what we see in practice.
Lower risk-adjusted after-tax returns
Sleeve-managed portfolios are burdened by higher drift and taxes than portfolios managed holistically.
This is because risk and tax are properties of the portfolio as a whole, not any individual sleeve, so there’s no way to handle the tax and risk of the portfolio optimally.
Let’s consider security-level substitutions and asset-class rebalancing to see why this is so.
Sleeves and security-level substitutions
With a “never sell” or “never buy” constraint, the best way to minimize drift is to look across the portfolio to find the most correlated substitute securities. But this isn’t possible if you rebalance each sleeve separately. Suppose, for example, there is an overweight position in IBM in sleeve one that you can’t sell because of a constraint or don’t want to sell for tax reasons. The best option for managing risk would be to counterbalance the overweight in IBM by underweighting a correlated security like HP. But if HP is in sleeve two and the sleeves are rebalanced separately, this won’t happen.
In contrast, with a holistic, sleeveless approach, there’s no barrier to this type of “cross sleeve” substitution precisely because there are no sleeves.
Sleeves and asset-class rebalancing
In a sleeve-based approach, rebalancing between asset classes involves selling down one sleeve and buying another. This is tax inefficient.
Suppose you want to sell appreciated large-cap holdings and buy mid-cap securities. With sleeves, you’ll, roughly speaking, end up selling every large-cap holding pro rata – likely incurring large realized gains – and buying a bit more of every mid-cap stock. To make matters worse, the large-caps you sell will include some of the smallest large-caps, and the mid-caps you buy will include some of the largest mid-caps. This makes no sense. The sale of the smallest large-caps to buy the largest mid-caps accomplishes nothing from a risk perspective but is likely costly in taxes and transaction costs.
The clunkiness and tax inefficiency of all this dictates that asset-class rebalancing should be infrequent in a sleeve-based approach. If, for example, there is a target allocation of 70% large cap and 20% mid-cap, you might not rebalance until large-cap is below 60% or above 80%. But this means that, on average, you’ll have about 5% asset-class drift.
In contrast, in a holistically managed account, you could rebalance from large cap to mid-cap when large cap gets to 69% or 71%. The reason is that there is no need to sell all large-cap stocks pro rata. Instead, you can:
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- choose to sell just a few stocks. In particular, you can preferentially sell those with the least appreciation or possibly even those with losses. It’s possible, of course, that these least appreciated securities may be similar, perhaps from the same industry or sector, but if you’re managing holistically, this is not a problem. When buying mid-cap, you can buy in the same industry/sector. When you’re done, you kept capitalization, industry, and sector on target, with minimal tax.
- narrow trades to those with the biggest impact on asset-class balance. Little is gained by selling securities that, while technically large-cap, are just above the threshold of mid-cap, only to buy securities that are technically mid-cap securities but just below the large-cap threshold. To minimize taxes, selling “larger cap” large-cap stocks and buying “smaller cap” mid-cap stocks is better.
- take advantage of every large-cap stock sale, even those primarily motivated by changes in the constituent securities of the large-cap model, as an opportunity to correct for your overweight in large cap (e.g., if you sold Ford to buy GM, some or all of the proceeds of the Ford sale could be used to buy mid-cap positions).
Because it enables asset-class rebalancing one security at a time, a holistic approach enables you to simultaneously reduce taxes, turnover, and expenses (because you can trade fewer securities and preferentially choose to trade those with the least tax impact) and reduce drift (because you can “fix” asset-class imbalances at much lower drift levels).
Do sleeve-based “UMAs” solve the sleeve problem?
The idea of a “Unified Managed Account” was developed in response to some of the problems of sleeves (the irony here is that the “unified” in “unified managed account” is simply trying to correct a problem that was unnecessarily created in the first place by introducing sleeves). Do UMAs solve the risk and tax problems sleeves create? The answer is no. And there is no solution. The problem is not technical, so it can’t be solved through better technology.
The idea of sleeves is to manage segments of the portfolio in isolation. The purpose of doing so is to facilitate sleeve-level performance reporting (see the more detailed discussion below on why some firms choose to work with sleeves despite their disadvantages). But if you start managing the portfolio holistically – say, you sell HP in sleeve two as a counterweight for holding onto IBM with short-term gains in sleeve one – then it becomes hard to make sense of the resulting sleeve-level performance report. The problem is, where do you put the extra IBM when calculating returns? Not in sleeve one (sleeve one’s manager wanted to sell IBM); not in sleeve two (sleeve two’s manager wanted HP, not IBM). Not in an “other” sleeve (that still leaves sleeve two with no HP).
The primary purpose of sleeve-level performance reporting is to aid in manager selection. That doesn’t work if each sleeve’s performance is affected by what’s happening in every other sleeve.
Why sleeves and householding don’t mix.
Householding means jointly managing a set of accounts to a common asset allocation. By its very nature, householding is holistic. Sleeves are not. Sleeves are, fundamentally, products. With householding, you’re not looking at individual products. You’re not even looking at individual accounts. You’re looking across all the household accounts to ensure that the combined holdings match the household-level target asset allocation.
If sleeves are so destructive in models-based portfolio management, why are they used?
If sleeves are so destructive to investors – and costly to boot – why do firms use them? The answer is partly just historical – sleeves were invented to allow third-party specialists to trade a portion of an account. When the industry began transitioning to a models-based approach, wealth advisory firms kept the sleeve structure. It wasn’t necessary or even helpful, but it was there.
Beyond simple inertia, the primary motivation is that sleeves facilitate sleeve-level performance reporting. You can report how each model is doing in each investor’s portfolio. The problem is that these performance numbers aren’t necessarily useful for evaluating the performance of the model vendors. It’s unclear whether sleeve-level performance reports are meaningful in a models-based environment.
If your sleeve-level rebalancing is "pure" – that is, each sleeve is truly rebalanced in isolation from the others – then sleeve-level reporting can be used to judge the performance of the model vendor in the context of the overlay management program. It is not strictly suitable for judging the model vendor in isolation. The sleeve-level performance will reflect the combined contributions of the overlay manager and the model vendor, and any poor performance may simply reflect the overlay manager’s poor execution.
However, the combination of model vendor and overlay manager is what the client is buying, so combined performance may be the best measure. If, for example, the sleeve underperforms because the overlay manager is too slow in implementing the short-term signals of the model vendor, you can rightly conclude that the model is not a good choice, given the overlay manager’s particular abilities.
But there are very good reasons not to manage the sleeves in isolation. As we mentioned earlier, risk and tax are properties of the portfolio as a whole, and you simply can’t manage a portfolio optimally if you manage its pieces in isolation. So, all sleeve-based systems allow at least some cross-sleeve influence, meaning that the holdings and trades in one sleeve affect the trades and holdings in another. For example:
- Wash sales – a trade in one sleeve prevents a trade in another.
- Tax and turnover budgets – trades in one sleeve are blocked because trades in other sleeves have caused the portfolio to come up against tax or turnover constraints.
- Cross-sleeve substitutions – an under or overweighted holding in one sleeve is counterbalanced in another (e.g., a “never buy” constraint on IBM in one sleeve is counterbalanced by an overweight in HP in another.)
When there is cross-influence of this sort, the performance of each sleeve reflects the combined influence of the model vendor + the overlay manager + the activity of other model vendors + the activity of the overlay manager in other sleeves. It’s worth looking at this in more detail. Here’s how each contributes separately to performance:
- The model vendor – Is their security selection good?
- The overlay manager – How good are they at executing the recommended trades? How good are they at implementing constraints in ways that limit return drift (i.e., what do they overweight/underweight when faced with a “never buy”/“never sell” constraint)? How good are they at balancing tax management and drift?
- The activity of other model vendors in other sleeves – This is the “cross influence” described earlier: The trade of one manager can, through wash sales, block the trades of another manager. Constraints can create an underweight or overweight that may spill into the holdings of another manager. And one manager’s activity can trigger tax and turnover budgets that block another from trading.
The problem with all this is that it's unclear how a performance report that reflects the combined contributions of multiple parties can or should be used. In particular, it can't be used to judge the model vendor or the overlay manager. The contributions of each are obscured by the actions of the other and what’s happening in other sleeves. It’s a bit like reporting on the combined times in a relay race – it doesn’t help you evaluate any one runner.
Sleeve-based accounting vendors recognize this problem and lean towards minimizing cross-influence in their rebalancing analytics. It's not that they don't know how to rebalance more holistically; it's just that the more they do it, the more degraded the sleeve reports become.
However, this minimal cross-contamination comes at a significant price in terms of higher dispersion, higher taxes, and excess cash. Minimizing cross-influence does not mean eliminating it, so sleeve-level reports are still unreliable sources of information to judge managers. In practice, the only instance we see of pure sleeve-rebalancing is with institutional accounts, where taxes and minimum position sizes aren’t factors, and it’s practical to more or less follow models exactly.
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So, whither sleeves? When we speak to a prospect, one of the first questions we ask is “tell us about your client meetings”. We want to learn what’s really important to the firm and their clients. If product selection, performance and trading are their central value proposition, they might want to stick with a sleeve-based solution. But if their firm is financial planning centric – if they aspire to be their clients’ lifetime financial coach, then they will want a holistic (sleeveless) approach. It’s not just that holistic approaches are better for the client. It’s that they think that drawing attention to sleeve-level performance reporting is a disservice to the client – not because the reported performance might be embarrassing, but because it misinforms the client about what’s important. Not all firms fall neatly into the “product/performance/trade” or “financial planning/coaching” buckets, so sometimes it’s not clear whether sleeve-based or holistic will be better for any given firm. What we can say is that the trend is towards holistic. For models-based portfolio management, sleeve-based approaches aren’t dead. But they’re dying.
Related reading:
- The Ultimate Guide to Sleeves, Part I
- The Ultimate Guide to Sleeves, Part II
- The Case Against Sleeves
- Q&A: The Case Against Sleeves
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