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Friday, July 21 2017

Wrap Fee Programs

In my seventeen years’ experience in the field of financial services compliance, the one thing that still manages to surprise me is when I mention the term wrap fee program to an individual registered to provide investment advice and financial services and they respond with, “what is a wrap fee program?”. For those reading this posting who are saying, “well, I don’t know what a wrap fee program is”, in simple terms it is a fee structure in which the asset management fee also covers the client’s trade costs.

As stated previously, in simple terms a wrap fee program is a program in which a client is charged one fee by the investment adviser and that fee will cover the cost of executing trades in a customer’s account. For those who are thinking that a wrap program sounds like a great marketing concept to attract customers, as far as regulation goes, wrap programs are a bit more involved than just paying for a client’s trading costs. Generally, there are three types of wrap fee programs.

The first to be discussed is what is commonly referred to as a self-sponsored wrap fee program, and is generally associated with smaller investment advisers. In this type of program the adviser charges an asset based fee and then pays for trade costs out of pocket. These programs are facilitated by institutional custodians who offer custodial services to registered investment advisers. Under this type of program the adviser will be required to set up and fund an escrow account associated with its master account with the custodian. As the adviser executes trades for its clients the custodian will debit the escrow account to pay for the trades in its clients’ accounts.

Another type of program is where an institutional custodian sponsors a wrap fee platform in which Advisers can subscribe. This program usually provides registered investment advisers access to platforms which offer a variety of models and fee schedules through which the adviser can actively manage its clients’ assets. This type of wrap fee program allows adviser to invest in models to which smaller investors that in most cases would not have access and is generally more convenient for the adviser because they do not have to worry about fee calculations, billing or ensuring their escrow account is adequately funded to pay for trades; the custodian will calculate fees, bill the client and then pay the adviser a percentage of the fee charged.

The final wrap fee program to be discussed is similar to the previous. This type of program provides the adviser access to third party money managers that have been engaged by the custodian to offer asset management to the subscribers of the wrap fee program. This type of program is the most convenient but most expensive in which to participate. The reason being is because the Adviser conducts due diligence of the money managers as opposed to the markets, does not have to actively manage client assets and does not have the responsibility of calculating fees, billing or paying for trades. However, the payout is generally very low because of these facts.

These programs may sound like a great deal due to the fact that clients just pay one fee and do not have to worry about what they will be paying for execution. However, as stated earlier, there are some regulatory issues to take into consideration in recommending a wrap fee program. What most do not take into account is the investment objectives and risk tolerance of their clients. This is where the recommendation of a wrap fee program becomes tricky. Generally, a wrap fee program is most beneficial to a client that has aggressive investment objectives and a high tolerance to risk, if, there is going to be active trading in their account(s).

I have seen so many advisers that only manage client assets through a self-sponsored or third party custodian offered wrap programs. In general this is not an issue, if, the fee the client pays is adjusted accordingly. This means that if all you offer is asset management through a wrap fee program, then the clients who have more conservative investment objectives and risk tolerance, and will more than likely not incur active trading in the account, that they better receive a lower asset based fee than those clients whose accounts will have more active trading. If not this could be considered a violation of the adviser’s fiduciary duty to its clients and result in a regulatory action being filed. So in summary, it is imperative to be aware of the need to evaluate each client, their financial situation, their investment objectives, their risk tolerance and the fees they will be charged for participation on a wrap fee program.