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Wraps Offer Convenience...At a Cost
04/18/2011 7:00 am EST
Wrap products are mutual-fund bundles commonly sold by banks to neophyte investors looking for a simple way to build a portfolio. But are they useful, or simply a way to charge high fees for unnecessary services? It depends on your desire for convenience, writes Rob Carrick, reporter and columnist for The Globe and Mail.
The independent fund analysts at Morningstar Canada stopped covering wrap products four years ago. Which is odd, because these all-in-one mutual-fund portfolios are stellar sellers.
“We just weren’t getting a lot of eyes on these reports,” said Philip Lee, senior fund analyst at Morningstar.
Seriously? People have invested upward of $146 billion in mutual-fund wraps, and no one wants to know more about what they’re buying?
That’s the wrap world for you: Investing neophytes buying prefab mutual-fund portfolios, mainly through bank branches. “I don’t know how many of these people go out and do their own independent research,” Lee said.
This Portfolio Strategy column is for people who buy wraps. If you’re not one yourself, pass it along, because lots of people are buying these things. Over the five years to February 28, sales of wraps offered by members of the Investment Funds Institute of Canada grew 132.8% in total, while standalone funds gained “only” 19.1%.
They Do it All for You...
Wraps are not known by that term once you step into a bank branch. Instead, they’re referred to by names such as “portfolio solutions” or “managed portfolio services.” That’s marketing talk, not investing talk.
But let’s not be too cynical—wraps, despite some serious faults we’ll look at shortly, can serve a useful purpose. “By and large, they can provide a good way of building a diversified portfolio,” Lee said.
When you buy individual mutual funds, it’s up to you or your investment advisor to combine them into a properly diversified portfolio. Wraps do that work for you. They hold anywhere from six to a dozen or more funds in a blend that instantly gives you a diversified portfolio tailored to various investing goals and risk levels.
Take the $1.3 billion BMO SelectClass Security Portfolio, for example. Its weighting to bonds includes Bank of Montreal mutual funds focusing on Canadian and global government and high-grade corporate bonds, plus a bit in a BMO high-yield bond fund (high-yield bonds are issued by companies with mediocre to weak financial stability).
The exposure to stocks includes the BMO funds covering Canada, the United States, Europe, and Asia.
Would an experienced investor or advisor be able to create something better? Absolutely. How about the kind of neophyte investor who buys funds in a bank branch? The Morningstar anecdote about investors not researching wraps suggests not.
Wraps also offer automatic rebalancing, which means they adjust your holdings periodically to make sure you don’t stray from your target mix of assets. If stocks are soaring, your wrap will pare your holdings. If stocks are sinking, your wrap will buy you enough to get back to that target mix.
Rebalancing is one of the greatest benefits of wraps in the eyes of Tom Dyck, president of TD Mutual Funds, which has sold more than $20 billion in wraps that go by the names Comfort Portfolios and TD Managed Assets Program, or MAP.
“Left on their own, people get emotional about their investing decisions, and quite often will do the wrong thing at the wrong time,” Dyck said. “I think that one of the greatest advantages of [wrap] programs is that the management of your money is left to professionals.”
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...But You’re Going to Pay
The drawbacks with wraps start with the fees. As is so often the case, convenience can be costly.
Not always, mind you. Dyck said some of TD’s Comfort Portfolios have fees that are a little bit less than the weighted average of the funds included in the product. In essence, investors have been getting a small discount.
More commonly, wraps charge fees to clients that are greater than they might pay if they used standalone mutual funds. One way they do this is to add an extra fee on top of the weighted-average management expense ratios (MERs) of the funds on which the wrap is built.
Mr. Dyck said TD does this in some cases with its MAP products, where the fees may be 25 to 50 basis points higher than the weighted average of the underlying funds. His explanation is that MAP fees reflect two levels of service—one from the TD advisor who sells the product and another from the money managers who oversee the MAP product itself.
“What you’re getting is a more complex solution—more oversight, more due diligence from our professional money managers,” he said.
Another way that wraps juice fees is by presenting the investor with a more expensive mix of funds than he or she might build on their own. Let’s go back to the BMO SelectClass Security Portfolio for an example.
This wrap includes a 5% weighting in BMO Guardian Canadian Large-Cap Equity Mutual, with an MER of 2.44%. This fund has decent long-term performance numbers, but the cost is high for something that holds big Canadian blue-chip stocks.
And then there’s a 2.5% weighting in BMO Guardian Asian Growth & Income-Class M, which has a too-rich MER of 2.84%.
Both of these choices are defensible from the point of view of building balanced portfolios, but they make the SelectClass Security Portfolio more expensive than it could be. That’s a common theme with wraps—extreme diversification that has the effect of boosting costs and, in turn, revenues for the banks issuing them.
Is there value here, at least? Not if a wrap is overdiversified to the point where the benefits of having professional money management get watered down to nothing.
Of course, it’s the packaging of wraps that matters to the people who buy them, not what’s inside. As Morningstar’s Lee puts it, “Any time something is sold as a one-stop solution or a portfolio solution, it tends to sell well.”
A better approach than wraps is to put together half a dozen or so low-cost mutual funds or exchange traded funds and do your own rebalancing once a year.
As for your mix of stocks and bonds, an old rule of thumb was to determine your weighting in stocks by subtracting your age from 100. With people living longer and needing more investment growth, the latest thinking is to subtract your age from 110 or even 120.
Wraps do win on simplicity and convenience. But don’t park your brain at the door of your bank branch before buying.
Four Questions to Ask About Wraps
Here are four things to ask someone selling a wrap:
1. What are the fees?
Ideal answer: The fees are the same or less than what you'd pay if you bought the funds in the wrap individually.
Watch out for: Wraps that charge a premium.
2. What are the returns?
Ideal answer: Better than average when compared against the appropriate mutual fund benchmarks.
Watch out for: Wraps that are fee traps—big costs, substandard returns.
3. What is the investment approach?
Ideal answer: Effective diversification for your investing needs, not overdiversification.
Watch out for: Wraps with more than 12 to 15 underlying funds—that's overkill.
4. What mutual funds are included in the wrap?
Ideal answer: Good quality, low-cost funds in core categories.
Watch out for: Expensive funds in fringe categories, with poor performers that you'd avoid if buying funds individually.