Separate accounts combine into one fee-based alternative the convenience of a mutual fund with the control of a brokerage account. However, there is a big difference between mutual funds and separate accounts that becomes important for a number of investors. Many mutual funds require an initial investment in the range of $2,000 to $3,000, and in some cases the amount can be as low as $1,000. (Initial investments are even lower for retirement accounts.) Separate accounts, on the other hand, typically require a minimum of at least $100,000 to $250,000, and in some cases it could be higher.

As more competition in this area occurs, the minimums will probably drop. Some people argue that separate accounts are more appropriate for investors with at least $500,000 to invest. For example, if you have only $100,000 to invest in a managed account, you would end up with a portfolio with one investment style. To achieve adequate diversification, most observers think you need at least $500,000 for managed accounts.

The big difference between mutual funds and separate accounts is, of course, ownership of the portfolio. With a mutual fund, an investor's money is pooled with that of other shareholders, and all shareholders collectively own the portfolio. In contrast, an investor in a separate account has direct ownership of the securities in the portfolio.

Separate accounts are not for all investors. The paperwork burden is much lighter in the case of opening mutual funds. Also, unless arrangements are made, the investor in a separate account could receive considerable information about the securities in the portfolio. However, a number of account programs allow the investor to set it up so that the advisor receives the information about the securities, thereby sparing the investor.

Separate accounts, like the other alternatives, have some weaknesses. For example, an investor interested in international investments would generally be better off with mutual funds. A number of mutual funds are set up specifically for international investing, and these skills are not readily available across the board.

Another potential problem is obtaining separate account performance data that will allow you to determine how well you are doing compared to other clients with separate accounts. Separate account managers are less regulated than are mutual funds, and they tend to disclose less information. In general, this information has not been publicly available. Morningstar, the well-known provider of information about mutual funds, plans to offer a newly devised ranking system for separately managed accounts in 2002. The ranking system will be available as part of its Principia software, which is often used by financial advisors.

Ironically, this could lead to the same thing that has happened in the mutual fund industry. Investors look at the rankings of mutual funds, which are based on historical data, and rush into those that have recently performed well. As we saw, many of these funds do not continue to perform well. On the other hand, it is difficult to make an argument against the disclosure of more information to investors.

It is also true that performance might be more difficult to measure when it comes to separate accounts. With a mutual fund, the manager makes the portfolio decisions and is therefore responsible for the performance of the portfolio. With a separate account, the investor ultimately controls the securities that are bought and sold for the account. If the investor decides to sell a certain security because he or she doesn't like what the company does, the manager does not have full control over the portfolio. In a similar fashion, an investor might decide to sell one or more securities solely for tax reasons.

With separate accounts, investors own the individual securities that have been selected for them by the account manager. Of course, with a mutual fund the shareholder owns the entire portfolio taken as a whole. Information about the securities owned is forthcoming very quickly, in contrast to information about the holdings of a mutual fund, which generally are disclosed twice a year.

It is in the area of tax efficiency that managed accounts can offer a real advantage over mutual funds. As we have seen, one of the biggest disadvantages of mutual funds is their relative inflexibility when it comes to taxable distributions. With a separate account, the cost basis is determined at the time the security is purchased. With mutual funds, a buyer could be purchasing embedded taxes because the fund has large gains that have been earned, but will be realized and distributed after you become a shareholder. In effect, purchasers of mutual funds are sometimes literally buying a future tax liability.

Consider also the situation in which the fund must sell securities to meet redemption requests, but would not sell these securities otherwise at this time. The shareholders then face unwanted capital gains taxes. With a managed account, the client has control over the sale of the securities, which should result in better tax planning. Taxes are not due until securities are sold, so control the sale date and you control when the tax is due. As the client, you can ask the manager to take some losses to offset some gains you have elsewhere. You can ask for a customized trade that fits your tax situation very closely.

In the final analysis, what is the difference between a mutual fund and a separately managed account? If the investor is not going to take an active role in the management of the account and ask for specific customization of the portfolio, in effect the managed account will function like a mutual fund. Unfortunately, it will be a more expensive mutual fund because the fees are generally higher than they are for mutual funds. The benefit comes when investors ask for, and receive, customized treatment.

Interestingly, account managers are not eager to supply customization because this interferes with their investing strategy. Nor are they eager to deal with the tax issue, because the manager is generally judged on the overall performance of the portfolio. If decisions are made solely for tax reasons, the manager's performance could be affected although the client's financial welfare could be enhanced.

Do investors currently take advantage of the customization features of managed accounts? Not according to available information. Information collected by Cerulli, a consulting firm, indicates that most of the new managed accounts that have recently appeared have no customization at all. The Cerulli study also found that when it comes to using tax strategies in these accounts, less than one third actually receive individual tax treatment. Why? Most of the owners never ask for it.

The bottom line is that many owners of separately managed accounts own what becomes, in effect, a more expensive mutual fund because they fail to capitalize on the advantages of owning a separate account.