What is a wrap account and what are the advantages of using one?
Wrap accounts, in which brokerage account costs are "wrapped" into a single or fixed fee, are great if you don't have time to invest on your own and wish to have a money manager take care of your assets. Charges are on a flat quarterly or annual basis, covering all administrative, research, advisory and management expenses.
There are two variations of wrap accounts: traditional and mutual fund. A traditional wrap account offers many different types of securities to meet the investment needs of the individual investor. The main attraction of traditional wraps is that they offer investors access to one or more investment managers to manage their funds. A mutual fund wrap account is a basket of mutual funds that caters to the investment goals of the investor.
The advent of wraps has allowed smaller investors to access professional portfolio managers, which were once only available to large institutional investors and the extremely wealthy. A traditional wrap typically requires an initial investment of at least $25,000. But with their ever-increasing growth and popularity, the deposit minimums are continually being lowered. Mutual fund wraps have relatively smaller investment minimums of as low as $2,000.
Another advantage to a wrap is that it protects investors from overtrading, or churning. This is when a broker or money manager trades an account excessively to create extra commission. Because the wrap account is charged a flat annual fee, the most you can be charged is the fixed percentage, usually 1-3%, of your account's assets.
For further reading, see Wrap It Up: The Vocabulary And Benefits of Managed Money and Introduction To Mutual Fund Wraps.
The other responses to your question do a good job of explaining the structure of a wrap fee, so I'll simply add that you should be aware of a few of the following implications of having your assets managed this way.
The first implication is simple: you prefer to have someone manage your assets for a fee rather than managing them yourself.
Next, you believe that it will benefit you to pay a larger management fee to have the advisor cover both management AND trading costs. This benefit is most likely realized if you believe that a strategy with more trading is effective in both investment performance and the fact that you wouldn't directly be covering the trading commissions.
Third, be aware of something called "reverse churning." If the advisor is footing the bill for trades, but is charging you a wrap fee, they have an incentive to trade your accounts less in order to limit their expenses and earn higher profits. I would tend to agree that limited trading or limiting costs, in general, is a good thing for investment performance, but if this is what you believe, you might consider whether or not you're better off not paying a wrap fee and just paying the trading commissions yourself. I believe it's important for investment advisors to limit conflicts of interest where they may arise and this structure can promote more complications.
Fourth, a wrap fee structure is less advantageous when the assets managed are larger. Simply put, it costs the same trading commission to buy 1 share of stock or 1,000. But since the wrap fee is often a percentage of assets managed, the benefit of the fee is diminished as the pool of assets is larger, assuming the same strategy is being employed.
Lastly, if you do engage in a wrap fee arrangement with an advisor, do the following annual checkup to see how you're faring. Take the difference between the wrap fee rate and non-wrap fee rate (if they offer one), then multiply that number by your average assets being managed for that year. This will give you a rough estimate of the fees you paid to pay for the wrap feature. From there, review that year trading history in Stocks/ETFs, Mutual Funds, Bonds, and Options. Determine the fee you would have paid for each trade and multiply by the number of trades in each category. This simple analysis will give you either the premium or discount you're receiving by being in the program. It will also be worth evaluating this in the context of your investment performance.
If you would like clarification of the above or would see value in a second opinion, please feel free to reach out.
Adam Harding, CFP
A wrap account is a brokerage account for which the client pays a management fee rather than pay commissions for individual transactions. The original premise behind fee-based management versus transaction-based management is sound. The incentive for the broker changes from activity to growing assets or client wealth and should align the interests of the broker with those of the client. This avoids accusations of "churning," a practice of excessive trading which some unethical brokers have used to generate commissions, not necessarily with the clients' best interests in mind.
However, the charging of a management fee implies active management of the account rather than merely monitoring of the account. So, there is a temptation for some brokers to convert large inactive accounts to fee accounts, in order to replace the lack of commission activity with fee income. This should not result in zero turnover of your holdings. For example, in a bond portfolio, there are often opportunities to replace more expensive bonds with higher quality or cheaper alternative bonds. Ditto for an equity portfolio. But often does not imply daily or weekly change for the sake of change.
Be alert to what you are being charged. For example, some wrap accounts which consist largely of mutual funds, charge a management fee for "wrapping" the portfolio as well as the underlying management fees of the mutual fund. How much asset allocation expertise is really being employed here?
We have also seen mutual fund wrap accounts operated by a large mutual fund sponsor in which the mutual funds were reallocated every two weeks. In broadly diversified mutual fund portfolios, that seems like too much allocation activity, at least, to us.
In short, investors should take time to discuss with their broker or advisor how the wrap account will be operated and what the objectives and goals are in order to ensure that your own interests and objectives are being met.
It depends on how much you trade and what the institution charges per trade. If you are a buy and hold investor and have few trades annually, then you don't need to pay higher fees for the wrap account. Wrap accounts just include the trading commissions, they don't change the level of service you should get from your advisor. Some institutions charge high trading fees/commissions so you need to weigh trades per year versus fees charged by the institution. If you self-direct your investments, you may want to try a discount brokerage firm like Interactive Brokers (I use them for as my custodian). Good luck!