Wraps: Cute, but fees are tough to swallow

ROB CARRICK,  Globe and Mail, Friday October 6, 2006

Carrick's first rule of investing: The cuter the investment industry gets in developing a product, the warier you should be about buying it.

With that warning out of the way, let's get up close and personal with one of the hottest and cutest investment categories of the moment, wrap accounts. Wraps are prefab portfolios of mutual funds designed to suit investors with various needs and objectives. There are conservative wraps for investors who want income, aggressive wraps for investors who want to grow their money and there are balanced portfolios that try to accomplish a little of everything.

In theory, wraps make some sense. They offer the simplicity of one-stop portfolio-building, and they can provide value in the process through which clients are matched up with an appropriate mix of investments. There's also a benefit in that the wrap managers have presumably found an eclectic group of funds to bundle together.

The problem with wraps is that they're too cute, which is to say they're mostly about using glossy packaging and puffed-up verbiage to hide an apparatus designed to generate income for advisory firms and fund companies. More income, as it happens, than mutual funds provide.

This is important context for understanding why wraps are hotter than funds these days. The data crunchers at Investor Economics tell us that wraps have grown in assets by a compound average annual 26.8 per cent over the past three years, compared to 10.7 per cent for mutual funds alone. In dollar terms, wraps have grown to $126-billion from $53-billion in 2000.

Strictly on their own merits, wraps don't deserve to have grown in popularity like this. Savvy advisers and do-it-yourself investors can easily create portfolios that cost less to own than wraps and deliver returns that are as good or, and this is no stretch, better.

So why are wraps such hot stuff today? Let's look at four reasons, each of them framed in a way that will help you ask the right questions if your adviser urges you to invest in a wrap.

1. Fees paid to the adviser

There's simply no doubt that one of the reasons why wraps are so popular today is that they frequently, though not always, offer fatter compensation to investment advisers than 99 per cent of mutual funds.

Here's the deal. When advisers sell funds, they and their firm receive ongoing monthly payments from fund companies to pay for client service. These so-called trailing commissions are a big part of the costs that mutual fund companies lump into the expenses they charge against their fund returns, and they typically amount to 1 per cent of the money you've invested in equity funds per year and 0.5 of a point for your holdings in bond funds.

Now, imagine you're a fund company with a new wrap program that you want advisers to sell. One way to get some traction would be to offer a juicier trailer. Thus we have many wraps paying trailers of 1.25 per cent and a few that pay 1.5 per cent.

These turbo trailers raise a question: Are you being put in a wrap because it works the best in helping you reach your financial goals, or because it pays your adviser a premium? Don't hesitate to ask this question of your adviser. A diplomatic way to put it: Does the wrap you're recommending offer a higher-than-usual trailing commission and, if so, what advantages are there for me, the client, versus the many alternatives with lower trailers?

2. Work done by the adviser

A big part of the work a financial adviser can do for you is to assess your needs as an investor and then select funds or other investments to help you achieve your goals. Over the years, an adviser should regularly monitor the portfolio to ensure that the various components are in the right balance, and that the funds in the portfolio continue to be productive.

Wraps do most of this work for the adviser. They typically provide the means to quickly size up the kind of portfolio a client should have, and then serve up that portfolio on a plate. Through automatic, continuing portfolio rebalancing, wraps keep stocks, bonds and cash in the right proportion.

Given this lightened workload, the extra-generous trailer paid by fund companies to advisers selling wraps is almost a scam. How can advisers justify it? There's only one way, which is to provide true financial planning services that might include advice in areas like taxes, estate planning, budgeting and debt management and such.

If your adviser recommends a wrap, then, an obvious question is: “What will you do to justify the premium compensation you'll be receiving?

3. Performance

There's just no point in buying a wrap unless the performance is equal to or better portfolios of individually selected funds or stocks and bonds. And yet, wraps vary widely in quality from out and out junk to pretty darn good.

The difficulty in assessing wraps for investors is that the marketing material for wraps can imply they're buying a premium product that presents a smarter choice than mere mutual funds. Truth is, funds are often the smarter choice.

Sometimes, wraps have too many funds mixed together in a way that short-circuits the usual benefits of diversification. The underlying funds themselves are usually defensible choices, but you can't call them the best of breed in most cases because they're typically chosen from the biggest fund families and rarely from smaller blue-chip firms.

Never buy a wrap without first asking your adviser to document how returns have compared in the past to an appropriate blend of benchmark stock and bond indexes, and to portfolios of top individual equity and bond funds. That way, you'll have a solid basis of comparison for wraps like TD FundSmart Managed Balanced Growth Portfolio, which has parlayed investments in a stunning 15 different global and Canadian equity and bond funds into returns for the past one- and three-year periods that were below average in the category of global balanced funds with an emphasis on stocks.

4. Fees for the wrap

Wraps for the most part are more expensive to own than mutual funds, and you can blame those supposed value-added features that separate wraps from funds. The new Meritage portfolios from Altamira Investment Services are typical in that the management expense ratio reflects a premium above the weighted average MER of the underlying funds.

“The difference enables us to provide investors and advisers with several value-added services including fund selection, monitoring, and rebalancing . . . and high-quality support tools, such as fund fact sheets and the website (meritageportfolios.com),” Glenn Cooper, Altamira's director of communications, explained in an e-mail.

These value-added services are integral to the wrap experience, but you have to question their worth because the cost will reduce your returns below what you could make in the underlying funds chosen separately.

Wrap fees are actually worse than they've been portrayed here so far. The underlying mutual funds in a wrap are usually a special variant that have extra-low MERs and are reserved for institutions and high-net-worth investors. So while the firm offering the wrap is getting a discount on the underlying funds, it's charging a premium to investors to own the whole enchilada.

With respect to your adviser, never buy a wrap without first getting a comparison of how the ongoing ownership costs — the MER, in other words — compares with owning a portfolio of funds. Remember, any MER premium in a wrap comes out of returns that would otherwise go to you, the investor.

By now, you should understand that wraps are a hot seller today because they're so lucrative to fund companies and advisers, and because they're cunningly packaged to make investors think they're getting something special. In many cases, they're not.