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Friday, July 15 2016

Wrap Fee Programs and the ADV

There seems to be quite a bit of confusion in the investment adviser community when it comes to wrap fee programs. In a nutshell, a wrap fee program is exactly what the name says; a platform in which a client pays one fee, a fee based on a percentage of the assets under management, which also covers the transactional charges that would typically be a separate expense billed to the client.

Generally, there are two types of wrap fee programs. The first being those sponsored by a third party service provider; most often the same entities that commonly provide institutional custodial services. The second type is considered a self-sponsored wrap program.

When participating in a third party sponsored wrap program, the institutional service provider will act as the sponsor of the wrap program and the adviser will act as the manager to the portfolios subscribed to the program. Some institutional service providers also have third party managed wrap programs where they will have a group of approved third party money managers to the wrap program. In this case when an adviser has determined that a referral to a third party money manager is more suitable to its client’s needs, the adviser can refer the client to the wrap program and select a third party money manager whose strategy is in line with the client’s investment objectives and needs to manage the portfolio.

A self-sponsored wrap program is where the adviser charges a fee based on the percentage of assets under management and also pays for the transactional charges out of its own pocket. With this type of program, typically the custodian will require the adviser to fund an escrow account from which transactional costs will be paid.

Wrap fee programs were created for one purpose; a less expensive option for clients whose investment objectives and risk tolerance necessitate active trading. So it is very important for any adviser that is considering any type of wrap program to ensure it has very specific suitability requirements in place to determine when it is appropriate to enroll a client in a wrap program.

As an example, you have one client whose primary objective is moderate growth and one client whose primary objective is aggressive growth. The first client’s investment strategy may include a mainly buy and hold strategy in mid and large cap stocks to take advantage long term appreciation and require infrequent reallocations. The second client’s objective would entail a more active trading strategy in small cap stocks to take advantage of short term gains and to avoid short term losses. If both clients have an account valued at $1MM and are paying 1.25% annually, typically, there is no problem. Now let’s say that the adviser has a self-sponsored wrap program and both clients are participating, and the adviser is charging 1.5% (an extra .25% to cover the transactional charges). Now, it is a different story; why is the first client paying the same fee as the second client when the first client is not costing the adviser nearly as much in transactional charges as the second client? In this case, you may have a regulatory auditor questioning you about over-billing of your clients. This is a very simple example, but is reflective of how wrap programs are viewed by the regulators. This example is also relevant to third party sponsored wrap programs as well.

Another very important aspect of wrap fee and non-wrap fee management fees is disclosure. Regardless of how client accounts are managed, as a fiduciary, investment advisers must disclose all fees associated with the management of its clients’ accounts. This is one reason why there is an ADV Part 2 Brochure and a Part 2A Appendix 1 of Form ADV Wrap Fee Brochure. Only the services and fees associated with non-wrap management of accounts should be addressed within the ADV Part 2 and only those fees and services associated with accounts managed as part of a wrap fee program should be should be addressed within the ADV Part 2 Wrap Brochure. It is important to remember to disclose custodial fees associated with accounts not being managed through a wrap program. So if an investment adviser has a client whose has assets managed within and outside of a wrap program that all fees associated with both are disclosed and explained. A failure to do so could result in action being taken against the investment adviser by the regulatory body, or bodies, with which it is registered, which is evidenced by this article.