WRAP ACCOUNTS

In a desire to gather more accounts from individual investors, brokers and their firms have instituted the use of wrap accounts. By definition, these are accounts where money managers invest and manage a group of investments consisting of stocks, bonds and cash funds for a set annual fee. There is at least $50 billion in the wrap market to date and it's growing tremendously.

The initial intent, and probably the major continuing aspect of such accounts, is to allay the fears of stock and bond purchasers that a single broker would merely be trying to sell products solely for the commission. As differentiated, wrap accounts charge the overall account an annual fee irrespective of how often the stocks within the account are bought or sold. Commissions are not charged to the investor. As one adviser stated, by removing the firm's vested interest in commission based products, its advisers would retain more objectivity and flexibility in structuring and moving client investments. Fees generally range from 1% to 3% (100 to 300 basis points) of the account value- perhaps 2% to 3% for equity accounts and from 1.25% to 1.75% for income accounts. The charges are also usually based on a sliding scale similar to that of break points on mutual funds- the larger the account, the lower the overall fees. Brokers may also discount the fees to better customers (20% to 30%) or when they simply want to gather additional accounts. The fees are split between the broker offering the account to the client, the money manager and the wrap account provider. Such splits may provide that one third goes to each party or perhaps 50% going to the broker dealer and the other 50% split between the money manager and the provider. A further split, provided by the WSJ noted the following breakdown on a 3% fee on a $100,000 account. $750 went to the money manager; $750 to the broker; $600 to the brokerage firm; $400 paid for the manager selection and $450 went to cover custody of securities and clearing charges.

NOT ALL BROKER DEALER FIRMS ACTIVELY SOLICIT WRAP ACCOUNTS

When a broker sells product inhouse, all fees are essentially retained by the broker dealer firm. But with wrap accounts, some of the fees go outside of the broker dealer firm to the managers and custodians of the wrap account. Therefore some firms are concerned that extensive use of wrap accounts by their brokers may lead to reduced income for their own firm. Though the use of wraps is increasing dramatically, it is unknown what bottom line financial impact will actually be felt by broker dealer firms- particularly the smaller ones whose income is from higher commissionable products.

FEES VS. COMMISSIONS

Viewed simply by overall charges, wrap account fees may not be that much different than those charged by an individual broker. The average or acceptable commission charge that a major firm expects from their successful broker's accounts averages around 2% to 3% per year. When charges exceed 3% on an ongoing basis, the NASD (National Association of Security Dealers) is apt to scrutinize the account for irregularities and excessive trading.

CONSUMER NOTE: Though a broker may give a discount on a transaction, or where the fees on a confirmation appear to be very small, the facts can be very misleading. Brokers may make VERY large fees through the sale of "market maker" stock- those stocks where the broker dealer firms has an inventory and acts for its own account. In such cases, total compensation may be over 10 times that received under a "normal" stock sale. However, due to the structure of the market maker category, the total compensation (the term compensation is different from the term commission) is within NASD guidelines- though it may well have created a conflict of interest and the sale of a potentially unsuitable investment. It is sometimes very difficult for consumers to understand what has actually happened within some of these transactions and skepticism is advised.

EXPERTISE

If the issue and concern of cost of cost is excluded, the investors motivation for a wrap account is the supposed added expertise and objectivity of a professional money manager. The manager of such an account is not subject to such "sales" requirements of a broker nor to the sales of products which the firms wishes to sell that day or week (because it might have an excess inventory, a sales trip is offered, etc.). The manager can decide what to do solely on the movement of the market and the individual stock selections of the industries he understands or analyzes. But not only is the review conducted for the initial purchase, but supposedly is ongoing. This continued monitoring of the portfolio is probably the greatest benefit to the consumer, since it is rare that either consumers or stockbrokers do this on a continual basis. No major stock firm has, to my knowledge, required their brokers to actively monitor client investments to be sure they meet or exceed certain quarterly benchmarks. Further, few brokers have the time- perhaps even fewer have the requisite knowledge and skills- to continually monitor investments they sell. This may be seen by the background comparisons of many wrap managers versus brokers. Wrap/asset based managers will have/should have significantly greater education, attainment of specialized designations (CFA- Chartered Financial Analyst being the most pronounced though others may apply) and have recognized achievement in the marketplace (hopefully) through industry awards. Additionally, and as stated, they are universally more objective in their recommendations while brokers, as a group, are almost always required to be positive in their approach and techniques. For example, prior to the October 1987 crash, brokers' buy recommendations outnumbered sells by 16 to 1. Even after in 1990, buy versus sells were still about 7 to 1. Wrap/asset based Managers are oblivious to such emotionalism- or at least should be. Therefore, wrap accounts monitored by competent advisers are a way of reducing the sales presentations of brokerage firms while increasing visibility and objectivity. Supposedly, this approach to the investment/investor would provide high returns and at an acceptable risk.

Recognize an issue in the above. Managers of accounts are involved in the analysis of one type of fund or asset type- growth, income, international, etc. They are not necessarily- in fact almost assuredly not- practicing asset allocation. That's the real key to your success and is addressed separately.

BROKER QUESTIONNAIRE

The degree of risk an investor is willing to take is a key element in the selection of the firm, the fund manager and the types of funds being utilized. It is absolutely incumbent on the broker to make sure the investor understand the risks. While all brokerage accounts require an investor/client questionnaire, the completion is insufficient, by and of itself, as an indicator of risk. The broker must have the personal skills and knowledge to ferret out the underlying assumptions of risk that the client will take. This has proven to be a major contention in arbitrations as regards the suitability of a particular investment for a client. Since such reviews are usually impersonal and take place over the phone, they rarely are that indepth (nor are really required to be by SEC rules). Further, they seldom encompass an analysis of any documentation by the client. This is particularly true if the husband is only present to open a joint account- or where the wife's input is essentially nonexistent. The broker must be careful if the husband demands- or is able to talk the broker- into a portfolio that is too risky considering past experience and investment size and net worth (See Pyramid of Funds and Pyramid of Investments). What may seem OK initially may haunt the broker years later where the wife (or other beneficiary) files an action against the broker for not using conservative investments or requiring her input. Similar scrutiny, I submit, is also required when a broker touts "safe" investments for retirement when he/she has not properly analyzed the clients needs or does not have the requisite skills to begin with . It is incumbent that the broker follow the rule of "know thy client". As such, brokers should not always do what the client wants. It's what the client SHOULD DO or NEEDS TO DO that are the controlling factors.

Other areas that the broker must analyze is the time horizon for such investing. The shortest time frame should probably be no less than three to five years- though that varies by the amount and type of stock and risk the investor takes. Shorter time frames may encounter poor economic conditions where the stock values drag down the overall account value. Longer term strategies invariably provide the greater return through stock appreciation. That is again identified by returns and volatility for stock indicated in many other areas herein. The broker must also determine the investment objectives (growth, income, speculative, etc.). Part of this determination is through a review of age, health condition, marital status, income, other assets, net worth, estate plans and other considerations. Such review should be also more encompassing (as already addressed) than a simple stock account if for no other reason than the size of the account is usually fairly large- and so is the liability if something goes wrong.

Based on the asset allocation mix, the broker and firm must conduct a wrap manager search reflecting expertise within the allocation defined. Many firms such as the large brokerage houses- may already have a (or two or three) manager(s) that they have researched and require be used. Shearson and Merrill Lynch are the two biggest firms with billions in such accounts of their own. Other smaller firms, particularly the independent broker/dealers, might allow the broker to select from several outside managers the broker dealer firm has reviewed. Such due diligence of asset managers may consider the returns the manager has posted for his/her type of fund (income, growth, international) against a benchmark index known by most investors. The S&P 500 index, the Solomon Bond Index and the EAFE index for international funds are just a few. The review must also consider the time frame- two, five or ten year periods- assuming the manager has conducted fund/asset management for such a time. Obviously, the review could utilize a hypothetical evaluation based on the manager's investment formula and strategies for a previous time frame if the manager has a short or nonexistent track record. However, these are usually seen as very poor substitutes for true experience and should be severely discounted for credibility- if used at all. In my experience, I wouldn't bother with them at all. Additionally, figures can be distorted. Some firms may use indexes more favorable (lower) that their returns (Wilshire 5000, Russell 2000, Dow Jones, S&P 400, S&P 100). Further, the returns for the 1980's reflected one of the strongest growth periods for decades and there are few advisers suggesting that the 90's will be as strong. Perhaps the choice of stocks by some managers was reflective solely from this market and not by expertise alone. And lastly, during this same period, many advisers did better than the S&P 500- but is the manager being reviewed one of the top 5% or 10% in his/her category or just against the one index? One can still surpass certain indexes and still be in the bottom of overall returns and capability as compared to other managers. It might behoove brokers to do some independent due diligence on such managers. In fact, it might be good to take the client to one or two of the managers selected and let him/her make the final choice. Though perhaps too cumbersome and confusing at times, it may actually solidify an account. These personal reviews should, regardless of who is in attendance, determine more than just the return background of the adviser. How long has he been there has already been addressed as a major concern, but how long he might stay there is certainly another concern. Has he/she skipped from one firm to another frequently? Or perhaps the firm itself has a tendency to fire managers at a whim. Does the manager actually conduct day to day operations or leave them to underlings? How many hours does he work? How many days per month or year is spent on company sites interviewing chairmans, presidents and visiting plant sites? For example, Peter Lynch was not only good, he worked hard- up to and over 80 hours per week. He also frequently visited company presidents. Though this was not all the reasons, certainly the two should play a part in a managers selection. All this is extremely important- more so to the client than the broker- but the brokers livelihood and trust is on the line.

In addition to these requirements, the program must also provide a system to collect custodial fees, allow for trading of stocks (again, for small broker/dealers, the trading and commissions may have to go through their account), provide for client reports (at least quarterly for good reporting) and monitor the performance of the manager.

But after all is said and done, is it actually worth while to take the advice of a broker and engage a manager through a wrap account? Though most investors are probably correct in circumventing the investment capabilities of their broker (save for an extensive verifiable track history), perhaps other investments might produce acceptable results at less costs. The initial benchmark for comparison is the S&P 500 index. A no-load fund such as Vanguard's 500 index mutual fund also has low annual management fees and has been used by the author on several occasions. First, the mere use of this index means that, during the last five years, 85% of equity fund managers did not meet this return. Recognize that 85% of professional managers do not, over time beat the index. But also recognize that if one is aware of economics and asset allocation, it is possible to at least meet the average with potentially lower risk.

WRAP ACCOUNTS

(1994) Here are some additional comments from Investment Advisor regarding some of the apparent and perceived problems with wrap accounts. First, quite obviously, is the high fee. Yes it can be negotiated down, but most small investors may not be given much reduction. It is usually cheaper to use a no load mutual fund and pay an adviser separately. That almost always is less expensive. Nonetheless, clients have been pouring an estimated $70 to $80 billion into these accounts with the major wirehouses accounting for 60% of that total. But a number of client redemptions have occurred nonetheless as they probably look to lower cost alternatives now that the market surge has cooled. This is particularly true of bond accounts. You can only charge so much with these until you see a loss. That's because with interest rates so low, any high expenses/fees can eat returns to nothing. Accounts under $500,000 are usually charged 3%, from $500,000 to $1,000,000, the charge might be 2.75% to 2.85%. Only when one gets over $1,000,000 may the fees drop to the institutional level. Secondly, not that many managers will beat the market in the first place so as some have seen their returns below the S&P level, they are opting to bail out as well. Other advisers note, as do I, that proper asset allocation simply isn't available with small accounts- some say under $500,000. Another critic notes that some reps- those that "help" a client select a manager- are really just selling the hot product of the day. They are selling the hot manager. They steer the clients into putting down answers that lead them to choose the manager the consultant likes. I think selling a particular hot manager puts the client relationships at risk and could sour the process."

There is another tricky problem here that the industry has addressed previously. And that is trying to get the information about the actual returns and expenses. They don't have to file the same information as a mutual fund- and many don't become Investment Advisors. Many publications have tried to get the info for the past two years and have found it severely lacking. This year they noted, once again, "we found the overwhelming majority of wrap managers not only unwilling to provide performance data, but also unwilling to provide the sort of basic information requried for clients to understand what is actually going on". Caution advised.

WRAP FEES: How is the 3% commission on a $100,000 account paid? $750 to the money manager; $750 to the broker; $600 to the brokerage firm; $450 to pay for manager selection and $450 to cover custody and clearing charges.

NEW MUTUAL FUND WRAP ACCOUNTS: 1996 In an intent to grab more of the marketplace, B/D firms are heavily focusing on mutual fund wrap accounts. Instead of a 3% charge, they apparently opting for a 1.5% wrap. This will unquestionably come down due to competition- at least from professional advisers who are now dropping under 1%. That said however, we still are left with the main crux for wrap accounts of stock or mutual funds by a B/D firm and its brokers. Unless there is some additional knowledge attained separately by the broker, there is so little provided in licensing training or, from my exposure to date of continuing education, that it makes little sense to pay 0.50%, never mind 1.5%.

Privately managed accounts: (NY Times 2003) Assets in separately managed accounts amounted to $398.7 billion last year. But the accounts usually have higher fees than mutual funds, and less-affluent investors may not receive much personal attention because advisers typically allocate most of their time to wealthier clients.

Most separately managed accounts sold through brokerage firms are actually miniaturized versions of master portfolios assembled by mutual fund companies or other investment managers.

A computer program ensures that each investor's individual portfolio tracks a master account. Though the adviser has the power to adjust a portfolio to meet individual needs, the notion that advisers are selecting shares with each investor in mind is, for the most part, a myth. (I say a joke. Further the whole issue is clouded with the element that an "advisor" has the capability and competency to actually understand diversification, alpha, beta, correlation and more.)

The average expense ratio of a stock mutual fund is 1.57 percent, according to Morningstar. That compares with an average of 2.05 percent for separately managed accounts.

Many smaller separate accounts are not well-rounded portfolios, but instead stress a particular strategy — like large-cap value or small-cap growth — which can be extremely volatile.