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Beware of Costly “Wrap Accounts”

June 2009

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One of Wall Street’s most popular offerings in recent years has been the “managed” account. It works like this: You have maybe $200,000 in savings outside of your IRAs and 401ks. You get tired of putting it in CDs and think you could make more money in funds. Or maybe you bought a bunch of tech stocks, thought you were a genius for a while and woke up in 2001 a good bit less rich. You know you need help. So when the “financial planner” you consult or the guy in the brokerage office asks you about your investment experience you say, “Not much,” or “I don’t really want to manage my own money.” “Of course we can help you,” is the answer. You are shown a bunch of colorful pie charts. Maybe you take a little test about your risk tolerance. A half hour later you’ve signed some papers and soon you’ll have a new account with a bunch of “hand-picked” “outperforming” mutual funds. So easy. “And you’ll never pay a commission,” says the salesman (oh, sorry, financial advisor). Is there a catch? Absolutely.

As with most things in the financial services industry, the first catch is fees—layers and layers of mostly hidden fees. The second catch is that ‘past performance does not guarantee future results’ and the most carefully selected mutual fund managers on average perform less well than the averages.

Between 1930 and 1975 the main source of revenue for the financial services industry was commissions—a transaction fee charged when a stock or bond is bought or sold. Those fees used to be fixed and very high. Then in 1975 the SEC eliminated fixed fees, and the discount brokerage business came into being. To keep profits high, much of the financial services industry turned to generating income by managing and selling mutual funds. The picture changed yet again in the 1990s, as the growing popularity of low-cost index funds pressured mutual fund profits. Wall Street quickly countered with a shift towards marketing “assets under management,” most typically in what are known variously as AUM, wrap, fund of funds, or managed accounts. The AUM game is played by persuading you to give the financial services company control over your money, which they will “manage” for a quarterly fee. Some account managers earn their keep, buying individual stocks, bonds and low-cost index funds (see this article for more details), but far too many managed accounts are little more than the latest way to extract fees and more fees from unwary investors.

David Jackson, of SeekingAlpha.com, points out that juicy, largely invisible fees are the primary reason these types of accounts are Wall Street’s most popular new products.

The typical managed or wrap account includes several players, each of whom gets a piece of the action. At the helm is the primary salesman—usually a broker or investment advisor who sells you on the idea, helps decide on asset allocation and communicates with the sub-managers. Unfortunately, as Jackson points out, the costs don’t end with the main advisor. In a typical wrap account, a group of sub-advisors or mutual fund managers manage part of the wrap account’s money. The primary advisor siphons off 0.5% to 1.0% per year of the assets in the account, while each sub-manager earns between 0.35% and 0.70% (bond managers earn less). In addition, there is generally a plan sponsor and a clearing and custody agent who takes another 0.15% to 1.0%. Investors with $300,000 or less will often pay as much as 2.7% per year when all the fees are added up; even investors with several million or more will often pay over 1.25%.

Further, because stock-oriented funds and accounts typically pay the manager more than conservative bond-oriented funds, there is a built in incentive for the managers to recommend a more aggressive allocation of assets, with far more stocks funds than bond funds, even if that asset allocation is not appropriate for you.

Adding to the problems, most wrap accounts are cookie cutter: once the asset allocation has been selected, the underlying funds are automatically bought. You cannot pick and choose among the funds and if you decide to change your asset allocation, the change is made all at once, with new funds replacing the old ones. A better way—rebalancing or making changes gradually over several quarters—never happens with wrap accounts because that would be more work and less profit for the managers.

Advisors commonly claim that their managed accounts will give you access to the best, most successful money managers specially chosen by panels of consultants—access that you could not get if you just went shopping for a mutual fund through a discount broker. But Yale University's endowment's chief investment officer David Swensen disputes the idea that there are special consultants who can justly claim to be able to pick the best sub-managers and mutual funds:

“Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital. If an investor can't make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There [are] also more fees on top of existing fees.”

Fortunately, there are plenty of excellent low cost alternatives. From managing your own money through a discount broker to shopping for inexpensive money management services, good options are out there. The key is not to lose sight of the most important issue, which is: how much is this going to cost me, and what's going to be left over for me after my manager has taken his cut?

Investors should not worry that paying less for financial services will mean that they will miss the chance to get rich with some mythical brilliant investor. Neither private wealth managers, nor hedge fund managers, nor mutual fund managers have proven that they can do a consistently superior job managing your money. As John Bogel, the founder of the Vanguard Group and the popularizer of index fund investing put it, "Performance comes and goes, but costs roll on forever." Swenson agrees that passive investing in index funds with low fees is the best alternative for most investors. And all the evidence has shown that even in markets as tumultuous as 2008 a simple portfolio of low-cost stock and bond index funds, rebalanced periodically, will beat almost all active managers almost all of the time.

At Responsible Investing, we can help you learn how to manage you own money or how to find and work with a good low-cost money manager. To learn more about our affordable independent advisory and coaching services click here.

Responsible Investing is an independent financial coaching and investment advisory firm, registered with the Commonwealth of Massachusetts.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Outside sources used in this article are believed but not guaranteed to be accurate. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.