It's a Wrap

Question: My broker has recommended a wrap account for me. What exactly is a wrap account, and what are the key things I should look into when evaluating one?

Answer: Wrap accounts have taken off in popularity during the past several years. Assets in wraps jumped up by 50%, to $1.8 trillion, between 2005 and 2010, according to Cerulli Associates.

Wrap accounts are designed to be one-stop investments, providing all-in-one diversification in a single account. That seems simple enough. But it's crucial to make sure you understand what you're getting into before entrusting your money to a wrap account.

At the first meeting with your broker or advisor, you should also obtain a copy of the account agreement, fee structure, and any other documents you would be asked to sign if you were to open an account. That way, you can take the paperwork home to read carefully at your own pace and make comparisons if you are considering investment professionals at several firms. Dig deeper into the fine print to locate all the information on potential fees as well as the securities the account can't hold (such as tax-deferred annuities and unit trusts). Beware if you're pushed to open an account on the spot.

As you conduct your research, focus on answering the following questions.

What Type of Wrap Is It?
Key to making sure a given wrap account is right for you is understanding exactly what you're that particular account would mean for you. Wrap accounts come in many different types and sizes.

One common type of wrap account allows a participant to choose from a preset menu of investments featuring a number of different stock/bond mixes. Taking into consideration your overall financial situation, risk tolerance, and goals, the advisor helps the client select the one that is the most appropriate. Mutual fund wraps typically follow this model. Exchange-traded fund wraps are also available in which ETFs are the primary investment vehicles rather than mutual funds.

Investors should keep in mind that unlike target-date funds, which get more conservative over time, most mutual fund and ETF wraps are static. Once the asset allocation has been selected, the underlying funds are bought automatically. You may not be able to pick and choose among the investments, and if you decide to change your asset allocation, the change is made all at once with the new funds replacing the old ones.

One other flavor of wrap account is the fee-based brokerage account. By paying a flat fee for a standard brokerage account, the client is allowed nearly unlimited, commission-free trading throughout the year. As part of the package, the client has the opportunity to consult with an investment professional and receive advice on security selection and portfolio construction.

What Are My Total Costs?
Wrap fees are commonly 1%-3% of the investment account's balance. One fee covers all administrative costs, commissions paid to your broker, transaction costs, and management expenses, including the costs of putting the whole package together as well as underlying fund management costs.

The exact percentage of the fee will vary depending on your broker/brokerage firm. Some brokers charge a consistent percentage every year, so when the account grows, they get a larger slice of the pie. Others charge based on a sliding scale--the larger the account, the lower the percentage charged.

But for sake of encouraging complete transparency, it's a good idea to ask them what the total charges will be, both in percentage terms and in dollar terms based on your asset level.

When all of the various levies are totaled up, wraps can be costly. However, by participating in a wrap plan, you may be entitled to buy lower-cost share classes than would be available to you by buying the funds directly.

How Much Help Do I Need?
Wraps are designed to provide you with soup-to-nuts portfolio management, which may or may not be what you need.

If you are confident in your ability to construct a sound portfolio, there may be no reason to pay for advice, and a discount broker may offer everything you need. If you are comfortable with a commission-based compensation structure and have confidence in your advisor, a traditional brokerage account may be the right choice. But if you prefer the benefit of ongoing professional assistance, a wrap account may suit you best.

Does the Wrap Structure Jibe With My Investment Style?
If you're an active trader, consider how many trades you intend to do in comparison with the wrap fee cost. Unlimited trading for a flat fee may be worth it because it gives you greater freedom to maneuver multiple and frequent switches and trades. But if you don't intend to trade much, a wrap account may be overkill.

On the flip side, those who don't need a lot of ongoing guidance and like to take a hands-off approach to their portfolios will pay more via a wrap setup than paying individual commissions for each transaction. And if you're a buy-and-hold investor with a taxable account, a wrap account may not be advantageous. In a traditional brokerage account, you'll pay commissions on your few transactions, but even if you need to pay an annual fee on top of commissions, it'll still most likely be less than the wrap fee.