Pooled Wrap Programs
Wraps are more sizzle than steak
We've seen headlines over the past year or two confirming the slowing sales of Canadian mutual funds. Sure companies like Fidelity, CI, Mackenzie, and AGF continue to lure investors' money but the remainder of fund firms, in aggregate, likely haven't seen much sales growth - if any at all. There is, however, a product that is picking up the slack - fee based products. More specifically, I'm talking about wrap programs. This week, we'll see why these aggressively marketed products simply don't deserve your money in most cases.
Have you ever filled out a questionnaire, at a bank or financial advisory firm, which asks you questions about your attitudes towards investment risk and return? You darken the appropriate circles to each question with your pencil and voila - a computer or scoring system tells you which of the firm's pre-packaged portfolios is best suited to your profile. Then every so often (maybe once annually), the portfolio is rebalanced back to that original mix. In a very general sense, that's exactly how wrap programs work.
There are three basic types of wrap programs that I've identified in the marketplace and they are differentiated primarily by the underlying investment vehicle used to structure recommended portfolios. Mutual fund wraps are basically packaged portfolios of regular mutual funds. Institutions offering mutual fund wraps often use their in-house funds as the underlying investments, while a couple firms use third-party or other firms' funds. Investors using segregated management accounts, by contrast, actually have direct ownership of individual securities. Fees for these programs are usually somewhat lower. In between these two extremes are pooled wrap programs, which use private pooled funds to structure their "model portfolios". Pooled funds are basically mutual funds with high minimum investments, and they're only available through the respective wrap programs. It is this latter type that we'll focus on this week.
Style diversification, a topic previously covered in this space, is at the core of the portfolio strategies recommended by pooled wrap programs. Some wrap providers aren't shy about using in-house managers on most, or all, of the underlying funds. Others prefer to stay independent of the investment management of the funds. The latter approach should appeal more to you, especially since that's the only way investors can be assured that managers are objectively monitored. Manager monitoring is another key factor in assessing the merits of any wrap program. It will come as no surprise that wrap programs that use primarily in-house managers handle manager monitoring internally, while those using mainly external managers have third party consultants keeping an eye on performance and style adherence. As always, there is an exception. Consulting firm Towers Perrin monitors performance and style for Dynamic's Viscount program, which uses internal managers for about one-third of the management duties.
,br> Aside from the initial profiling and periodic rebalancing most pooled wrap programs will provide clients with a written proposal or investment policy statement (IPS) to accompany the recommendation of an investment strategy. The depth and quality of various firms' IPSs varies widely from the skinny version given to Viscount clients to the full and comprehensive version generated by Merrill Lynch's Frontiers program.
In general, most clients of wrap programs should expect a higher level of service than you'd otherwise receive from your advisor if you were invested in regular mutual funds and/or securities. The higher level of service primarily refers to the more personalized performance reporting that is standard with such programs. You should expect personalized rates of return compared against some benchmark that is customized to your investment strategy.
Standard fees for wraps range from 2.5 to three per cent per year and can range quite a bit higher. In fact the lower end of the range is downright fuzzy. If you have at least $250,000 available to invest in one of these programs, you'll have some negotiating power on fees. The problem: many programs give no clear indication of the exact range of negotiation room. Some programs define clear upper and lower ranges while others only define a maximum fee. To some extent, negotiated fee discounts are often shared by your advisor and "the house". Discounts in excess of a certain amount usually come entirely out of the advisor's pocket. Also, beware of additional fees that may be charged. While nearly all wrap programs provide monitoring and rebalancing as standard features, not all do, so make sure you ask. Okay, there's actually only one wrap program that charges 0.6 to 0.7 per cent extra each year for monitoring and rebalancing but I'll get to that in another column soon.
The smoke and mirrors of deductible fees
Probably the greatest misconception about wrap fees is the fact that "they are tax deductible because you pay them directly, unlike those high mutual fund fees". That's just a bunch of baloney. Sure, wrap fees may be tax deductible but so are mutual fund management expense ratios or MERs. MERs are effectively deductible because they reduce the amount of taxable income that you see on your T3 each year. In fact, the deductible portion of wrap fees is only that paid for custodial services and advice on buying and selling securities. Further, only that portion paid in respect of non-RRSP/RRIF money is deductible. Hence, many investors could find that none of their wrap fees are deductible depending on the portfolio structure and the services provided.
I examined the real tax difference in a hypothetical comparison of two identical balanced portfolios. The difference: the wrap version had management fees invoiced directly to the client, and the mutual fund version charged fees directly to the fund. I found that the deductibility of wrap fees provided an after-tax advantage of 0.17 per cent annually. Yes, that is some advantage but that also assumed that wraps and mutual funds had equivalent fees. In reality, this slim advantage is more than offset by the fact that the average balanced mutual fund portfolio has fees that are easily 0.50 per cent cheaper per year in most cases.
It's no secret that I'm not a fan of wrap programs. Fees are high, the ability to customize recommendations is poor, and the benefits just don't measure up to the extent of justifying substantially higher fees. While many programs may disagree and say that their program is the exception to my general rule, I do have one word of advice.
Always look at the annual fees in dollar terms based on your proposed investment. If you're planning to invest $200,000 in a wrap with fees of 2 per cent per year, ask yourself if the services promised are worth the $4,000 in annual fees plus GST (remember that dollar figure rises as the portfolio grows). Hence, always compare what you're paying to what you're getting in return. In the end, only you can decide if it's for you.
To read my recent wrap research in its entirety, pick up the February and March issues of Canadian MoneySaver magazine (http://www.canadianmoneysaver.ca).
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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