What is a brokerage wrap account?
In a standard brokerage account, fees are generated every time there is a transaction. Brokers with clients in such accounts have the incentive to come up with reasons to trade. Notorious practitioners often churn client accounts, buying and selling frequently to beef up their own income at the expense of their clients. When caught, these brokers and their firms are punished. In an attempt to maintain fee income and remove the incentive to trade, the wrap account was created.
Wrap accounts charge owners a set fee, usually 1% to 3% of assets, with an annual minimum, perhaps $1,000 to $3,000. For this fee, the client can trade as often or infrequently as desired. Usually there are a maximum number of included trades, with marginal trading fees added when that maximum is exceeded. Often other services, like sending wires, checking, and such are free or otherwise covered within the ‘wrap’.
Why you should avoid brokerage wrap accounts
Damaging sales fees
Wrap fees do not pay for money management. Wrap fees are sales commissions. Their damaging magnitude assumes fairly active trading at the highest possible cost. Wrap fees wipe out much, perhaps all, of the income you might receive from dividends and bond interest. Based on historical returns, wrap fees can inhibit stock growth by 20-30% or more.
Figure 10-1 exhibits the reduction to returns on stocks, bonds, and a balanced portfolio of each for the decade 2008-2017. Figure 10-2 shows the impact on dollar growth for the two decades ending 2017. Invested in a 50/50 allocation between stocks matching returns on the Standard & Poor’s 500 and bonds performing apace a blend of high grade bonds*, $10,000 would have grown to over $39,000 from 1998 to 2017. Invested in the exact same manner in a wrap account with a 1.5% fee, the ending balance would instead have been about $29,000; a $10,000 hit on a $10,000 investment.
Lack of service
When an account generates commissions on each transaction, there is incentive for a broker to come up with reasons to trade, whether the ideas are well-intentioned or not. With a wrap account, wherein fees are earned regardless of activity, there is little incentive for a broker to come up with any ideas. In fact, the goal of most client facing brokers is to gather assets for their firm and put those assets into accounts that generate continuous fees. These charges will grow regardless of service, allowing the brokers to move on to gather more assets. Wrap accounts commonly get little attention.
Double charges for management
The wrap fee you pay merely compensates salespeople. If you want actual asset management, your money will either be placed into mutual funds or into a consulting arrangement whereby a third party will manage your portfolio. In both cases, management fees will be charged, all supplemental to the already-harmful wrap fees.
Marginal legality
In 2007, the U.S. Court of Appeals for the D.C. Circuit deemed wrap accounts based solely on annuitized commissions to be illegal. The court held that the firms charging these fees must be held to fiduciary standards consistent with the Investment Company Act of 1940. In response, the major brokerages created “comprehensive” wrap accounts through which advice would be provided to fee paying clients. Unfortunately, these firms did not send their salespeople to graduate business programs or other institutions where they might have learned something about portfolio management. The new brochures became wordier, the reports more graphically intense and the jargon laced with impressive terms. But the wrap accounts are essentially the same, and the “advisors” and “consultants” proffering them are still salespeople.
What you should do instead
Plain and simple, do not open a wrap account. If your money is in a wrap account, get it out. Open an account at a discount broker such as Schwab or TD Ameritrade or Vanguard (Appendix A) and transfer your assets. If you want active management by a devoted portfolio manager, seek a good and fiduciary registered investment advisor (Chapter 50).
* Data sources:
Stock returns: S&P Dow Jones Indices LLC; Standard & Poor’s 500 Index.
Bond returns: Federal Reserve Release H-15; An index of equal parts (25% each) Moody’s Aaa corporate bonds, Moody’s Baa corporate bonds, 5-year Treasury bonds, and 10-year Treasury bonds, rebalanced annually.
Balanced returns assume 50% each stock and bonds, rebalanced annually.
Wrap fee: 1.5%