The Rap on Wrap Accounts

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If you've gotten within spitting distance of a major wirehouse broker lately, you might have been pitched a "fee-based" investment program. The advent of these so-called "wrap accounts" is arguably the most significant pricing development in the industry since commission deregulation opened the elite playing field to discounters on "May Day" in the 1970s. Like old

John Denver

albums, fee-based programs have been gaining popularity but still elicit a mixed response from clients and brokers alike.

The Basics

Wrap accounts are the brokerage house equivalent of an amusement park's flat admission fee. Pay the clown at the gate once and ride the coasters all day for no extra charge. In the brokerage biz, the term "wrap" generically refers to any plan where you pony up a fixed percentage of your assets as a management fee (usually from 1% to 3%) instead of forking over a commission every time you trade a stock or buy a mutual fund.

Wrap accounts come in a variety of flavors. One pretty common example is the mutual fund "supermarket," which allows a participant to choose from thousands of different load and no-load funds and consolidate them all in one basket account. Usually, these programs come bundled with some kind of asset-allocation model that helps each client select an appropriate portfolio based on their individual investment objectives and then keeps the weightings automatically balanced over time.

Other programs simply wrap a standard brokerage account with a flat fee and allow nearly unlimited, commission-free trading throughout the year. Some of these programs also add some bells and whistles like proprietary investment models that generate suggested trades on a regular basis.

One of the obvious advantages of wrap programs is the theoretical alignment of broker incentives with a client's best interests. Under a fixed-fee arrangement, the sticky temptation for a broker to make stock recommendations merely to rack up commission dollars is removed from the equation.

Suddenly, the brokers and clients are sitting on the same side of the negotiating table instead of being locked in some kind of quasi-adversarial wrestling match. Both sides have a personal incentive to grow their accounts through prudent investment choices rather than one side supposedly trying to push a blinding flurry of commission-generating transactions.

For some clients, just knowing that the prospect of a commission doesn't lurk behind every broker's call is comforting.

Although the brokers' payment in the fee-based model is a constant percentage of assets every year, when the account grows in size, they get the same fraction of an even bigger pie. In other words, 1% of $200,000 is twice as much as 1% of $100,000 regardless of how many trade tickets were dropped during the year.

The Real Appeal

The real reason firms are jumping on the wrap account bandwagon, however, is the predictability of the revenue stream that they represent. During the sunny days of a bull market run, firms haul in commission dollars by wheelbarrow. Clients are happy to take profits and move on to the next thrilling ride in euphoric bliss while new money clamors at the fence to get in on the fun.

If (or more accurately, when) the storm hits, however, investors get drenched with a stinging downpour of cold reality. Brokerage commission revenues dissolve as the crowd slinks home to dry off and wait out the tempest.

Wrap accounts, on the other hand, offer a steady stream of fees regardless of the market climate because they aren't dependent on trading volume. A firm with X amount of dollars in fee-based programs at the beginning of the year can pretty much rely on a fixed return off of those assets from day one, regardless of how the markets shape up in the coming months.

The same benefits accrue to the individual broker as well, causing personal incomes of wrap-oriented advisers to approximate regular salaries instead of wildly fluctuating periods of lean months with occasional windfalls. For brokers, wrap accounts offer the means to concentrate on portfolio performance instead of sales strategies to make their monthly commission goals. Over time, some guys in our office even reported a noticeable reduction in their consumption of "broker candy" (Tums, Advil, and B-1 tabs gulped by the handful throughout a typical branch office to stave off stress- and alcohol-related maladies).

Downside

Good for clients, good for brokers, good for the firm -- sounds like a triple-win situation, right? Well, not necessarily.

Many of the old-school brokers have been slow to adopt the fee-based methodology, preferring the gambler's rush to a steady paycheck. Other brokers balk at the suggestion of wrapping their biggest traders for a 1% fixed fee when they average higher than that during the course of normal business. Firms themselves have also been slow to respond to the trend, offering certain account options only to their biggest clients or best-producing brokers and leaving the bulk of their reps in the cold.

On the other side, some clients feel that the fees are too high to justify the meager benefits offered by such arrangements. Bond investors and buy-and-hold advocates are particularly sensitive to the fee structures, arguing that even 1% is higher than their average annual commission costs. Still others find the prospect of paying both a mutual fund management fee AND a wrap fee an anathema. (Note that loads are generally waived in these funds.)

The Factors

Here's some things to think about when pondering a wrap. If you're considering a mutual-fund-type wrap account, consider your investment style first. Do you like the idea of having all of your funds consolidated in one account and intend to do a lot of frequent switching or rebalancing? If so, a wrap account may be a good way to go.

For the flat fee, you get thousands of investment choices and easy, no-cost switching. These features can be particularly applicable for IRA accounts, where consolidation is a major convenience and taxes from such switches are not a factor. Conversely, if you intend to buy a few funds in a taxable account and hang on to them for life, then a wrap program might not offer much of an advantage.

For stock investors, it depends largely on how many trades you intend to do on average compared to the size of the wrap fee. For an active investor getting unlimited trades at a flat 1% of assets, the deal might be worth it, especially since it frees you to skim smaller-point moves without worrying about covering the round-trip commission. A less-active investor getting a limited number of trades for 2.5% might be better off on the pay-as-you-go plan.

As with most situations in the brokerage field, there are no easy, prepackaged answers. Just as each investor has a different profile of needs, attitudes and goals, brokerage firms offer scores of different features, criteria and fee scales for their account options. In light of this complexity, making a blanket statement that wraps are good or bad is impossible.

What's for sure is that wrap accounts are here to stay. Like the recent explosion of talk radio, whether you love the programs or hate 'em, at least you've got more choices. Enjoy the variety, and be sure to check out all your options before deciding which account is right for you.

Andrew Greta, an occasional contributor to TheStreet.com, is a business student and onetime stockbroker who lives in West Lafayette, Ind.