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.
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.
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, B.Comm.,
CFP is Senior Investment Analyst with Sterling Mutuals Inc. He can be reached
at dhallett@sterlingmutuals.com. Sterling Mutuals is registered as a mutual
fund dealer in Ontario, British Columbia, and Manitoba.