The Ultimate Guide to Sleeves, Part I

We want to talk about sleeves. Not the things on your shirt, but sleeve-based portfolio management, sometimes called partitioned portfolio management.

It’s not the stuff of cocktail party chatter, but it goes to the heart of how you manage wealth. The answer you give to the “sleeves” vs “no sleeves” question will shape your entire program.  

This is the first of two parts. Part 1 reviews the basics of defining sleeves and laying out pros and cons. Part 2 will discuss alternatives to sleeves. We won’t claim to be neutral here — Smartleaf is, after all, a leader in supporting sleeveless (holistic) portfolio management — but if you bear with us, we think you’ll find it useful.  

So, roll up your sleeves (as it were), and let’s get started.

What Are Sleeves?

There are three types of sleeves that sometimes get conflated:

1. Sleeve-Level Accounting (AKA “sub accounting” or “partitioning”). Sleeve-level accounting is the process of breaking a single account into virtual subaccounts (or “sleeves”) by tagging each tax lot to a particular subaccount.
2. Sleeve-Level Rebalancing. Sleeve-level rebalancing, in its purest form, is the practice of rebalancing each sleeve in isolation from the others. More generally, “sleeve-level rebalancing” describes any rebalancing process where the presence of the sleeves has some effect on rebalancing.
3. Sleeve-Level Reporting. Sleeve-level reporting is the practice of reporting the returns of each sleeve/subaccount separately.

The reason these three types of sleeves are sometimes conflated is that they usually go together. This is partly unavoidable —  sleeve-level rebalancing and sleeve-level reporting require sleeve-level accounting. But the reverse is not true. In particular, it is possible to have sleeve-level accounting and sleeve-level reporting without sleeve-based rebalancing. You can achieve this by merging all the sleeves each day, rebalancing the account holistically, and then dividing the account back up again. In this workflow, the existence of sleeves has no effect on trading. The question, which we will address later, is whether sleeve-level reports without sleeve-level rebalancing is useful.

Why Sleeves?

Sleeve-Level Accounting allows you to divide up management of one portfolio among multiple sub-advisors, each of whom gets trading authority over a segment of the portfolio. Especially if you have more than one manager in the same asset class — say, two large cap managers — you need to give each manager their own isolated portfolio to manage. However, this division of responsibility for managing a portfolio is becoming less common. It’s being replaced by “overlay”, where one person (the “overlay manager”) does all the trading. Third-party “managers” may provide models, but they don’t actually manage the account. The overlay approach is operationally simpler and makes tax and risk management easier. The more traditional sub advisory approach, where each manager directly controls a portion of the account, still makes sense if the underlying strategy requires specialized expertise in trading, as might be the case with municipal bonds or micro-cap strategies.

Sleeve-Level Rebalancing makes sleeve-level reporting (see below) more meaningful. The less “cross influence” there is between sleeves, the more sleeve-level reporting will reflect the performance of the model the sleeve is following. There’s effectively no way to avoid sleeve-level rebalancing if different managers independently trade their own sub-accounts. For overlay managers, it’s a choice, motivated by the desire to have cleaner sleeve-level reports.

Sleeve-Level Reporting is a form of performance attribution that, in some circumstances, can be useful for evaluating the performance of a manager. It’s intended to be a form of product-level performance report, similar to separately reporting the returns of each mutual fund in a client’s account. This type of product-level reporting is common in many programs and some clients will expect to see it. For most firms, providing sleeve-level reports is the main driver for sleeves. We’ll revisit this in part 2. 

Why Not Sleeves?

If sleeve-level reporting is common — often even expected — why not make this the universal approach? The not surprising answer is that there is are downsides to sleeve-level accounting, rebalancing and reporting. The drawbacks are important and worth looking at in detail. 

Sleeve-Level Accounting
The drawback of sleeve-level accounting is added cost and complexity:

• Sleeves require that you set up and maintain a “shadow” accounting system that keeps records of the holdings of each sleeve, and you need a reconciliation process to make sure that when you add up the holding in each sleeve, it equals the holdings of the actual portfolio.   
• Sleeves make cash management more complex. Every account will generate its own cash level from distributions. These are either siphoned off regularly in separate transfers to a sweep account or every account maintains its own cash balance level. In a holistic account, there is just one cash position.
• A similar problem arises with any security that is held in more than one sleeve. Each will have to separately obey lot rounding and minimum trade size constraints, which will introduce some additional drift. Optimal tax-lot selection for sales requires some mechanism for swapping tax lots between sleeves so that any given sale can be done with the best tax lot available.  

Sleeve-Level Rebalancing
There are two drawbacks of sleeve-level rebalancing: 

1. Inferior tax and risk management: 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 if each sleeve is managed in isolation. As a result, sleeve-managed portfolios usually have more drift and are less tax efficient than portfolios managed holistically. 
   • Suppose 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 this by underweighting a correlated security like HP. But if HP is in sleeve two, this won’t happen if each sleeve is rebalanced separately. The same issue arises with finding substitutes for positions you can’t buy.
   • Asset class rebalancing becomes “blockier”and less tax efficient, increasing average drift and reducing tax efficiency. In a sleeve-based approach rebalancing between asset classes involves selling down one sleeve and buying another, potentially involving dozens or even hundreds of trades. This dictates that asset class rebalancing be infrequent, which increases asset class drift. In contrast, in a holistically managed account, “asset class” rebalancing can take place one security and one trade at a time. In the above example, if large cap was overweight, then every large cap stock trade would be an occasion to transfer some large funds over to mid cap (if you sold F to buy GM, some of the proceeds of the F sale could be used to buy mid cap positions).
   • Asset class rebalancing is also less tax efficient. Suppose you want to tax efficiently rebalance at the asset class level, selling appreciated large cap holdings and buying mid cap securities. Optimal tax management  would dictate against selling the large cap securities that are just above the threshold of mid cap just to buy mid cap securities that are just below the large cap threshold. In a sleeve-based approach, this type of sophisticated tax vs. risk logic is not really feasible — large cap securities would be sold roughly pro rata and the mid cap securities would be purchased roughly pro rata.
     
     
2. Complexity: Sleeve-level rebalancing is also operationally more complex. For example:
   • Assuming each asset class gets its own sleeve, asset class rebalancing requires transferring funds or securities between sleeves.
   • In a sleeve-based approach, each sleeve typically has its own cash position. This complicates the task of funding withdrawals, paying fees, and preventing overdrafts.
   • As noted earlier, if you want to reduce taxes through optimal tax lot selection, you’ll need a process for swapping tax lots between sleeves (if, say, you want to trim exposure to a security in sleeve 1 but the best tax lot is in sleeve 2). If you want to avoid simultaneously buying and selling the same security across two different sleeves, you’ll need some sort of cross-selling matching process.

Sleeve-Level Reporting
The drawback of sleeve-level reporting is that, in most cases, the reports are not always useful — or, arguably, even meaningful.

There is an exception, 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 speaking, 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.  

On the other hand, as soon as there is any cross influence between sleeves then the usefulness of sleeve-level reporting starts to break down.

By “cross influence,” we mean 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 — substitutions in the presence of constraints, loss harvesting or gains deferral, etc. take place across sleeves, 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, 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 executing the recommended trades? How good are they at implementing constraints in way that limits 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 under-weight or over-weight 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 activity of the overlay manager in other sleeves — If the overlay manager is trying to control drift.

And if a sleeve-level report can’t be used to judge the model vendor or the overlay manager, what is it good for?

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 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.

If cross influence between sleeves is eliminated entirely, sleeve-level reports remain useful. In practice, the only instance we see of pure sleeve-rebalancing is with institutional accounts, where taxes and minimum position sizes aren’t a factor, and it is practical to more-or-less follow models exactly.

Given These Drawbacks, Why Use Sleeves If You Don’t Have to?

As we noted earlier, if you want to give discretion over a portion of a portfolio to a sub-advisor, you need sleeve-level accounting. However, the main reason firms implement sleeve-level accounting and rebalancing is that they want to provide clients with sleeve-level reporting. But if sleeve-level performance reports aren’t really useful, what’s the point?

The answer we see is that some clients, especially institutional clients, will ask for or even require sleeve-level reports. Logically, the case against sleeve-level reporting is strong: it’s costly, injurious to the interests of investors and usually doesn't provide useful information. However, this damning list can easily be viewed as moot if the client expects it. So, ultimately, the question becomes not about best practices, where sleeves arguably just lose, but client expectations.

This puts wealth managers in a bind. If sleeves are bad for clients, but clients want them, what is the right course of action?

More on that next week.