'Unwrapping' the wrap fee account

Patricia Foster,
BridgeTower Media Newswires

As technological advances in recent decades have made it possible for investment managers to manage thousands of small accounts simultaneously, wrap fee programs have emerged as a popular service offering for many investment firms that work with retail investors. For example, firms that do not actually manage client portfolios may recommend these programs to their clients because they provide access to third-party investment management expertise. But wrap fee programs do not suit the needs of all investors, and regulators have identified concerns of importance to investors. In this column, we take a look at two popular types of wrap fee programs, separately managed accounts and mutual fund asset allocation programs. We also outline for investors important considerations that have been identified by regulators.

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Wrap fee basics

The defining feature of a “wrap fee” program is that it provides bundled investment management and trade execution services for a single fee which is generally based on a percentage of the value of the account. These programs are typically sponsored by a registered investment adviser (IA) or a registered broker-dealer (BD). Client accounts are managed on a discretionary basis in accordance with a pre-determined investment strategy. The IA, which serves as the manager of the program, structures accounts of the individual program participants as “substantially” similar portfolios. The portfolios should not, however, be identical in composition because regulators would be likely to view that structure as an unregistered mutual fund. In an effort to avoid that characterization, the program must be structured to provide “individualized” investment advice to each program participant.

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Separately managed accounts  

The “separately managed account” (SMA) is the quintessential wrap fee program. It provides the retail investor with access to third party investment expertise which might otherwise not be available because of account size. The SMA sponsor generally structures the program to include “best in class” portfolio managers that have established track records in one or more asset classes. These programs are sometimes referred to as “manager of managers” programs. The SMA sponsor is required to deliver a wrap fee program brochure to participants before or at the time that they enter into a contract. This brochure provides investors with important information about the program and the fees that they will pay.

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Mutual fund asset allocation programs

The mutual fund “asset allocation program” is a distinct type of wrap fee program in which the manager selects a basket of mutual funds in which assets will be invested accordance with a pre-determined investment strategy. The mutual funds are selected based on the asset class or classes in which the various funds invest and on the track record of each portfolio manager. Investors should be aware that, in addition to the fee that they will pay to the program sponsor, they will incur the underlying fees and expenses for each mutual fund in which an investment is made.  

Regulators have provided a notable exception to the program brochure delivery requirement in the case of mutual fund asset allocation programs. The rationale is that, in contrast to other wrap fee programs, which provide portfolio management and brokerage services for a single fee, mutual fund asset allocation programs simply involve asset allocation services. Nevertheless, the sponsor of a mutual fund asset allocation program will be required to provide program participants with information about the program and a prospectus for any mutual fund in which they invest.  

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Industry perspective — business solution

The investment management industry has evolved to include approximately 13,500 firms that are registered with the U.S. Securities and Exchange Commission (SEC). These firms currently serve more than 42 million clients, 95% of which are individuals. However, not all of the advisers registered with the SEC (RIAs) actually manage portfolios of individual securities. Some of these firms recommend that their clients participate in wrap fee programs because they provide third-party investment management expertise. For these firms, the wrap fee program is a viable business solution. 

Because RIAs are subject to a fiduciary standard that applies throughout the entire relationship with their clients, the RIA who recommends that its client participate in a wrap fee program must determine that the recommendation is in the client’s best interest at the time the recommendation is made and that it remains in the client’s best interest throughout the course of the relationship. Moreover, the RIA must make sure that its client will actually receive individualized investment advice as a result of its participation in the program. This customarily means that the program sponsor will, among other things, manage the client’s account based on the client’s financial situation and objectives and in accordance with any reasonable investment restrictions imposed by the client. Firms that sponsor or recommend wrap fee programs are expected to be familiar with the safe harbor established by the SEC that outlines various specific conditions that a wrap fee program can follow to ensure that program clients receive individualized investment advice.

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Regulatory perspective — investor protection

The SEC’s investor protection mandate involves an assessment of market risks and other matters of importance to retail investors, especially those investors who are saving for retirement. Wrap fee programs are a significant regulatory focus.

Five years ago, the SEC enhanced disclosure requirements for registered investment advisers who serve as a sponsor of, or a portfolio manager for, a wrap fee program. Since then, the SEC’s Division of Examinations (formerly known as the Office of Compliance Inspections and Examinations) has continued to highlight wrap fee programs as a priority in its examination program. 

A 2020 enforcement action illustrates many of the concerns that regulators have about wrap fee programs — conflicts of interest, undisclosed fees and expenses and undisclosed compensation.  The case involved a firm dually registered as an IA-BD, which agreed to a settlement with the SEC of approximately $18.2 million in connection with the operation of its wrap fee programs.  The SEC found that this firm breached its fiduciary duty to its advisory clients that participated in its wrap fee programs, pursuant to which clients paid an all-inclusive fee for by: (1) charging certain fees to clients contrary to its disclosures; (2) recommending that clients purchase and hold certain mutual funds and mutual fund share classes that resulted in additional revenue to the firm without disclosing the inherent conflict of interest; (3) failing to disclose that it received revenue sharing payments on client investments pursuant to an agreement with its clearing firm, which also allowed the firm to avoid paying certain transaction fees for its clients’ purchases of mutual funds; and (4) recommending bank sweep vehicles for which the clearing firm paid the adviser additional undisclosed revenue.

On July 21, 2021, the SEC’s Division of Examinations announced the results of a sweep exam that involved examinations of more than 100 advisers associated with wrap fee programs, including advisers that served as portfolio managers in, or sponsors of, wrap fee programs; and advised client accounts through one or more third-party wrap fee programs. The examinations focused on three specific areas consistent with the SEC’s mission of investor protection: (1) whether advisers had fulfilled their fiduciary duties in recommending wrap fee programs; (2) whether advisers provided full and fair disclosures to their clients participating in the wrap fee programs (e.g., fees, expenses and conflicts of interest); and (3) the effectiveness of advisers’ compliance programs. The results of the sweep identify a need for improvement in each of these areas.

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Considerations for investors

Investors who currently participate in wrap fee programs and investors who are considering participation in a wrap fee program are encouraged to review all program documents, including contracts, relating to the program and to ask questions. Caveat Emptor!

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Patricia Foster is a securities law attorney whose experience includes representation of clients in both registered and exempt securities offerings, as well as in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. This column is a collaborative work by Patricia Foster and David Peartree. David Peartree is an adviser with Brighton Securities Capital Management, Inc., a registered investment adviser offering fee-only investment and financial planning advice. The information in this column is provided for educational purposes and does not constitute legal or investment advice.