What is an ETF Wrap
An ETF wrap is a type of special investment portfolio in which an investor, with or without the aid of an investment advisor, invests solely in exchange-traded funds (ETFs). The composition of each ETF class is initially based on a pre-selected asset allocation model and will periodically need to be rebalanced in response to changes in market values.
BREAKING DOWN ETF Wrap
Common asset allocation models for ETF wrap fee programs are 100% equity, 100% fixed income or a balanced model, which contains both fixed income and equity. The choice of model depends on an investor's age, tolerance to risk, income, goals and other personal factors. Investors can choose to manage an ETF wrap themselves in a non-discretionary account or elect to have a professional do so on their behalf in a discretionary account.
The Securities and Exchange Commission (SEC) defines a wrap fee program as one “under which any client is charged a specified fee or fees not based directly upon transactions in a client's account for investment advisory services (which may include portfolio management or advice concerning the selection of other investment advisers) and execution of client transactions.”
Simplicity is one of the primary benefits of a wrap fee program. Clients pay an annual or quarterly fee for wrap products that manage a portfolio of investments, rather than paying individual commissions for trades. For advisers who charge fees based on assets under management, these money management charges for wrap products often are additional — either billed to the client separately or through a higher adviser AUM fee to cover them.
ETF wraps are beneficial due to their low expense ratios when compared to mutual fund wraps. In addition, discretionary wrap programs may offer investors asset allocation and rebalancing services to keep their portfolio in line with their investment goals. One additional benefit of mutual fund wrap programs – access to fund managers typically not available to retail investors – is less applicable to ETFs, which are more widely available direct from the ETF sponsor.
Limitations of Discretionary ETF Wrap Programs
Wrap fee programs involving both mutual funds and ETFs are an ongoing focus of the SEC. Wrap programs are expected to protect clients from superfluous account activity, or churning. But the opposite problem can occur if there's little trading in the account as the financial advisor is not providing value for the wrap fee being charged. In other words, buy and hold investors and those that trade infrequently are exposing themselves to unnecessary fees by electing for a wrap program over paying commissions for each trade.
Advisors employing ETF and mutual fund wrap programs have also been scrutinized for charging high fees as well failing to adequately disclose the brokerage commissions they pay to trade investments within wrap programs. In some cases, the SEC has found that wrap fees inclusive of brokerage commissions were much higher than the commission costs borne by the advisor.