Wall Street's Windfall In `Wraps'Jeffrey M. Laderman
Wall Street thrives on marketing new financial products. And the hottest one now is the "wrap" account. What's being wrapped into a package for individual investors is financial planning, investment management, and brokerage commissions. With investors shoveling billions into these accounts, wraps promise not only to make a bundle for brokerage firms but also to change the way the Street deals with customers.
Brokerages have already amassed an estimated $40 billion in wrap accounts, the bulk of it in the past 18 months. Shearson Lehman Brothers Inc., with some $15 billion in 107,000 accounts, has new money coming in at a rate of $400 million a month. Money is pouring into Merrill Lynch & Co. at the same clip. Richard Schilffarth, a brokerage-industry consultant, forecasts that wrap-type programs will command a cool $3 trillion in assets by the year 2000. That's roughly twice the amount of assets in mutual funds today. Even if he is half right, wraps will be the greatest success story in financial history.
To open a wrap account, an investor needs at least $100,000. Working with the customer, the broker develops a financial plan, helps the customer select the right money manager--usually from outside the firm--to implement it, and then monitors the manager's performance. For this service, the investor pays a 3% annual fee on the value of the account. That fee "wraps" all costs for the service, including all commissions for buying and selling stocks and bonds.
What's critical in selling the wrap idea to a customer and making it work is identifying the customer's tolerance for taking risks and then matching that with a money manager whose investment style falls in the same risk category. The process should lessen the chance that investors will find themselves in unsuitable investments. And by enlisting money managers from outside the firm, the brokers assure customers that they are searching for the best possible fit.
Still, the 3% fee might sound high. Indeed, for the client to best the Standard & Poor's 500-stock index, his money manager would have to earn, on average, at least 3 percentage points a year better than the market. That was no sweat for many managers in 1991, but it's proving difficult this year (table, page 68). And over long periods of time, it's almost unheard-of.
BETTER BOND. Whether the wrap investor ends up beating the market remains to be seen. But what is already clear is that the wrap setup puts brokers and clients "on the same side of the table." Paying brokers an asset-based fee instead of a trading-based commission does away with the temptation to trade merely for the purpose of generating commissions. And because excessive trading, or "churning," is one of the major sources of customer suits against brokerage firms, the growth of these wrap accounts could possibly improve Wall Street's image with the public.
Only a minority of brokers, perhaps less than 20%, have enrolled clients in wrap programs. Some brokers don't have enough clients who can meet the $100,000 minimum. Others are wary of "sharing" their best customers with the firm and an eutside money manager. Still, those who embrace wraps say they free up time, and improve investment results. Says one brokerage executive: "A good broker is not necessarily a good portfolio manager."
Wraps are already proving to be a rich lode for brokerage firms. This year, wraps could produce more than $1 billion in gross revenues. That's not a lot considering that full-service brokerages grossed $27.8 billion last year, but all agree that wrap programs are still in their infancy. More important, perhaps, is that unlike commission income, which is highly volatile, fee-based wrap revenues are fairly predictable.
ELITE CORPS. Brokerage firms aren't the only ones enjoying the wraps bounty. It has been a bonanza for the money-management firms selected for the wrap programs, bringing business they otherwise would never get. There are some 17,000 registered investment advisers, but most wrap programs offer only several dozen. Wrap-program executives say that's because relatively few meet both performance standards and have the organization in place to run large numbers of individual accounts. Rittenhouse Capital Management Inc. in Radnor, Pa., is one of the champs of wrap, having taken in $2.3 billion through referrals from seven brokerage firms. Regent Investor Services Inc. in White Plains, N.Y., has nearly $1 billion in wrap assets, and Roger Engemann & Associates in Pasadena, Calif., has $750 million.
In return for managing the investments, the money manager gets 0.5 to 1 of the 3 percentage points that the brokerage firm charges. Part of what's left goes to the account executive who enrolls the client and services the account. The brokerage firm gets the rest for trading, custodial, and portfolio-monitoring expenses--and, of course, a profit.
On the surface, wrap accounts may look like mutual funds, and many wrap managers, such as Avatar Associates, Nicholas-Applegate Capital Management, and Roger Engemann & Associates, also run mutual funds. But in buying a mutual fund, an investor gets shares in a portfolio of securities. In a wrap account, a portfolio is created for each investor. Investors get monthly reports and a confirmation statement every time a stock is bought or sold--just as they would with a conventional brokerage account. Investors have some say in their accounts, too. Those who don't want tobacco or gambling stocks, for instance, can say so, and clients can also direct money managers to take gains or losses on individual securities for tax-planning purposes.
Wraps differ from funds in other ways, too. The law is specific on how mutual funds keep their books and report their results to investors. Not so with separately managed accounts. The Association for Investment Management & Research has a standard for calculating portfolio performance, but it hasn't been universally adopted. With wraps, a client is dependent on the brokerage firm to monitor performance.
GRAY AREA. Not surprisingly, the rise of wraps has also caught the attention of regulators. Marianne K. Smythe, director of the Securities & Exchange Commission's Investment Management Div., says her staff has been looking at wrap accounts "in a low-key way for about a year." She declined to cite any outright violations of the law. State securities regulators are struggling to draft uniform disclosure rules for wrap accounts, and this fall, a proposal is expected to be presented to a national group of state securities regulators.
The rap on wrap from its critics is that the 3% fee is high compared with alternative forms of managed investment, mainly mutual funds. The average expense ratio for an equity mutual fund in BUSINESS WEEK's Mutual Fund Scoreboard is 1.29%. But that doesn't include brokerage commissions, an estimated 0.34 percentage points, which are paid out of fund assets. Mutual funds sold by brokers have up-front sales loads and/or ongoing "12(b)-1," or distribution, charges, all of which tend to raise the expense of owning funds.
For some, the all-in-one fee may be a smart choice. Investors who trade frequently with a full-service broker can easily run up commission expenses at least as high, if not higher, than the wrap charge. "If you trade like I do, a wrap makes a lot of sense," says money manager Louis Navellier, who manages wrap accounts. Last year, his accounts had 200% turnover, meaning a $100,000 portfolio generated $200,000 in trades during the year.
Although fees may be high on minimum accounts, costs usually drop by half a percentage point for every $500,000 in an account. But these fees, like most commissions, are negotiable. Says J. Arthur Urciuoli, a Merrill Lynch senior vice-president: "We permit consultants to do some discounting based on their relationship with the client."In fact, the competition for wrap accounts is so keen that investors can often get a break on the fee just for the asking. Neil Johnson, a managing director of investment consultant Hamilton & Co., thinks there's plenty of room for wrap fees to come down. Says Johnson: "For the services involved, the cost should really be no more than 1.5%."
As the differential in costs between wrap accounts and mutual funds narrows, individuals will turn more and more to wraps. Russ Prince, president of Renaissance Applied Research, a Carmel (Ind.) market researcher, says surveys of high-net-worth individuals show they weigh reputation, confidentiality, and services far more than investment performance or fees. That goes a long way toward explaining why wrap accounts are taking Wall Street by storm.