The taxonomy of Wraps
Posted: Thursday, October 07, 2004
by Trevor
TheWealthNET
Definitional problems are endemic to the wealth management sector. Take the term ‘private bank’ for example. This can refer to a corporate structure (a privately owned bank as opposed to a state-owned bank) a specific corporate structure (a bank owned by its partners instead of shareholders as in the case of the Swiss partnership banks) or a business activity directed at a specific market segment (the provision of financial services to rich clients).
But even if one can resolve this particular definitional problem there are other conundrums to resolve. How do we define “rich" for example or “high net worth" or “ultra-high net worth (very rich)?
The arrival of “wrap" products looks set to provide more problems. Many consultants, especially those based in the US produce reports on a regular basis that extol the virtues of the wrap concept and its capacity for growth. The wrap market is one of the fastest growing segments of the US wealth management market, for example. And, given that the US is often a precursor of things to come in the UK, if not other Anglo-Saxon markets, the inference is that ‘wraps’ will soon become a common feature here.
The problem is, however, that the concept has probably already arrived, both in the UK and, perhaps of greater relevance to the evolution of the wealth management sector during the twenty first century, in Australia. It either just uses a different name. Or the term “wrap" is used to refer to something slightly different.
Take the UK, for example. Here the term “wrap" or “wrapper" typically refers to a discrete product that has some form of tax advantage that distinguishes it from a near equivalent. “Personal Equity Plans" (PEPs), “Individual Savings Accounts" (ISAs) and insurance bonds, for example, are “wrap" products in so far as they all have a “tax wrapper".
Moreover, on closer examination, many US “wrap" products are already available in the UK (and other European markets, for that matter) and have been for some time. The US “managed account" does not look too dissimilar, for example, to the segregated portfolio management account offered by any number of private client investment management firms. In Italy the gestioni patrimoniali in fondi market (GPFs) also shares many similarities to the US managed account or “wrap".
Then there is the Australian version of the “wrap" account. In some respects this looks the most interesting of the “wrap" alternatives. It could also provide the potential for wider replication throughout the world (excluding the US). The Australian version of the “wrap" account is something that has a much wider embrace: a platform that facilitates the management of all a client’s assets within one integrated account and for a flat fee.
The taxonomy of US wrap accounts
Most historians of the wrap or managed account sector credit New York-based Hutton Investment Management as the pioneer of the concept. It launched the first managed account product in 1976. It had a virtual monopoly in this respect until well into the 1980s when Merrill Lynch started its Consults fee-based programme. Prudential and Paine Webber launched similar products at around the same time, a move that was replicated by other institutions.
According to Boston, Massachusetts-based Cerulli Associates, a research and consultancy firm, there are basically five main categories of wrap programme.
1. Consultant Wrap . Here managers that are typically unaffiliated with the wrap sponsor manage investors’ assets in separate accounts. In other words the wrap sponsor outsources day-to-day portfolio management to an outside specialist. The accounts may hold stocks, bonds and other securities. Account minimums normally range from $100,000 to $250,000, with all-inclusive annual fees of between 2.5 percent and 3 percent.
2. Mutual Fund Wrap . This is in essence a managed portfolio of mutual funds. Account minimums are typically between $10,000 and $50,000 with an annual management fee of around 1.25 percent.
3. Proprietary Wrap . This is a discretionary fee-based account managed by the sponsor firm’s internal asset management division.
4. The Representative as Portfolio Manager Wrap . Here financial representatives, such as registered investment advisors, act as money managers for their clients.
5. Fee-based Brokerage Wraps . Here active traders pay an asset-based fee of around 1 percent for all trading rather than paying commissions on individual trades. These programmes may also offer advisory services.
According to Cerulli Associates, the Consultant Wrap programme accounted for around 40 percent of the US market in 2002 followed by fee-based brokerage (21 percent), the Mutual Fund Wrap (17.5 percent), the Proprietary Wrap (11.5 percent) and the Representative as Portfolio Manager (10 percent).
Recent innovations
The managed account concept has been extended in the US over the past two years to embrace so-called multiple discipline accounts (MDAs). These are also known as multiple style portfolios (MSPs) and multi-manager portfolios (MMPs).
MDAs attempt to resolve the problems posed by the need to secure proper diversification. To secure a proper level of portfolio diversification an investor might have to hold accounts with more than one investment manager. This stems from the fact that most firms tend increasingly to focus on different segments of the investment universe rather than on the market as a whole.
But this poses a number of problems. It may be difficult to obtain valuation statements that reflected their entire investment portfolio (i.e. consolidated statements). Furthermore, tax management and diversification became difficult because each separate account manager working for an investor would make decisions in isolation. These could have dire consequences.
Take an investor with two separate accounts, one focused on growth stocks and the other on value stocks. Suppose the former manager considers Citigroup to be a growth stock and the latter classifies it as a value stock. If both managers hold the stock for the investor diversification is not being achieved. Furthermore, if one manager sells the stock to harvest a tax loss and the other manager unwittingly buys it within 30 days a “wash sale" is created which effectively nullifies the loss (at least in the US).
The MDA solves this problem by offering separate accounts through a single advisor. This permits the investor to achieve diversification without entering into a multiple advisor relationship and secure consolidated statements and performance analysis.
Citigroup Asset Management pioneered the MDA around two years ago. Many other firms have since followed its lead.
The MDA model has evolved further to incorporate the role of the overlay portfolio manager (OPM). This functionary sits between a client advisor and the separate account managers to discharge a number of functions.
These include asset allocation responsibilities allowing account managers to focus exclusively on investment-related activities the provision of portfolio oversight to minimise security overlap between different accounts, avoid wash sale scenarios and meet the investor’s diversification needs more precisely and deal with tax management-related differences.
The’ full-wrap’ alternative
Some industry experts, especially those based in Australia and the UK, would contend, that the MDA, together with its antecedents, goes only some way in fulfilling the criteria of a ‘full’ wrap programme. For them a ‘full’ wrap programme shares many of the characteristics of another phenomenon that has emerged in recent years, - account aggregation.
In this particular variant the “wrap" is essentially the platform that consolidates all financial assets held by an individual into one account to facilitate holistic wealth management rather than focusing on a more restricted range of assets, such as financial securities and mutual funds. Pensions, life assurance policies and a plethora of other tax-advantaged financial products can all be held, and managed within the structure.
According to Allan Shields, a senior analyst at London-based Datamonitor, a research and consultancy company, a “full" wrap product has five distinguishing features: it can hold virtually any financial asset it can accommodate any tax regime or tax wrapper it commands a full suite of financial tools to facilitate holistic analysis and management it can be accessed online and charges a single transparent price. “It is not a managed account or a managed pool of mutual funds," he said. Mr Shields calculates that there are probably around £1,768 billion of potentially wrappable assets in the UK.
Readers with a long memory should also recognise the similarities between this concept and the “Wealth Account" described in Charles Sanford’s visionary paper “Financial Markets in 2020" more than ten years ago (see Wealth Management, January 2000).
Wrap programmes based on this model have already appeared in Australia, and have started to emerge in the UK, together with programmes that appear to replicate the US variants.
The ‘full-wrap’ advantage
Proponents of the full-wrap concept claim it provides a number of advantages over existing wealth management models from the standpoint of the client.
The first is that facilitates holistic wealth management. In turn this facilitates a number of efficiencies, such as ‘efficient’ portfolio management. The wealth manager can control asset allocation over almost the full spectrum of financial assets, for example, including pensions and life assurance products. As with MDAs security overlap between different products can be minimised. The assets within the ‘wrap’ can also be managed to secure tax efficiency.
The second advantage is that all these assets can be managed on payment of just one annual fee. Based on a proportion of assets under management within the account this fee covers all transaction and management costs.
This leads onto a third advantage. Lower costs should help generate higher net returns. This could be particularly important if annual assert returns revert back to single digits, as many experts predict.
Wrap providers can charge lower fees because they effectively outsource many of the technical functions, such as fund management (in the case of “managed accounts"), accounting and administration and other functions, to outside specialists.
All this leads on to another advantage, proponents of the wrap model claim. In essence the wrap model is essential premised on the outsourcing and ‘open architecture’ or ‘open choice’ models. Most of the products contained within the wrap, such as investment funds or discrete portfolios are effectively selected by the client in conjunction with his wealth manager or adviser but effectively managed by outside parties. The wrap programme can also take care of a variety of accounting and administration functions.
The result is that the adviser or wealth management firm that employs the wrap model can spend more time focusing on client service rather than on other functions such as account administration. The net result is a much higher level of service with the adviser better able to help clients solve wealth management-related problems and realise pre-set goals.
Wrap providers
In theory any number of firms can provide wrap programmes, especially those that deal with clients of a face-to-face basis, that is banks, insurance companies, private client brokers and investment managers and a wide range of intermediaries such as independent financial advisors.
Indeed, much of the interest surrounding the concept, at least as far as the UK is concerned focuses on just who will provide ‘wrap’ platforms and the form these will take. At this stage it looks as if the few wrap services that have been announced mimic the US version by providing either access to a range of external fund managers or mutual funds rather than the full wrap alternative. Nonetheless, these are very early days.
One of the attractions of the concept, quite apart from providing a model that might be extremely relevant to the ‘affluent’ and ‘emerging affluent’ segments of the wealth management is that it could considerably empower relatively small wealth management firms and IFAs at the expense of current industry giants. The wrap platform effectively puts the client adviser at the wealth management process rather than product providers or manufacturers. It could also accelerate the bifurcation of the wealth management sector between manufacturers and distributors.
But product manufacturers, such as banks, insurance companies and mutual fund firms are hardly likely to give up a significant proportion of their private or retail client base without a fight. As such it is almost a foregone conclusion that they will offer their own wrap offerings if the model does take-off.
The constraints
There are a number of constraints, however, which will limit the speed with which the ‘wrap’ vision can be implemented, especially within markets like the UK. This is especially the case as far the all-embracing “full-wrap" version is concerned.
Technology is not an issue. The technology systems already exist which can facilitate the implementation of “full-wrap" programmes. Indeed, the technology was around at the time Mr Sanford drafted “Financial Markets in 2020". Many existing portfolio packages can, and do, already accommodate tax-advantaged “wraps" such as PEPs and ISAs.
There are, however, a number of legacy-related issues to be overcome, however, especially as far as financial product design is concerned. The fact is that many UK pension and insurance products cannot easily be held, much less managed within a full wrap account. This is clearly the case with occupational pension scheme assets, for example. But even the realm of personal pension and Self Invested Pension Plans (SIPPs) there may also be problems.
There are also pricing-related problems. As Mr Shields points out it is not viable from the client’s point of view to place assets held and managed within a pension provider within the wrapper. He would be paying two sets of management fees.
Nor is it probably viable to transfer assets from a pension provider to those of a wrap-compliant provider (which would probably have to be the wrap provider). The assets ‘lost’ in transfer fees would probably be significant.
Thus the extent to which “wraps" could capture “legacy" assets from the pensions and life assurance sectors is probably limited. The focus, as far as this particular market segment is concerned, would probably have to be on new business, or on those “wrapped products" that can either be transferred relatively easily, such as SIPPs, or can be held and managed within a “full wrap" structure without any problems, such as mutual funds.
Within the UK there are also legislative constraints, although these should soon be removed. At present the polarised sales regime could limit the efficacy of the wrap concept, especially within the retail segment of the market, limiting clients to a range of financial products provided by a single provider.
These constraints would not, however, affect most established wealth management firms that cater for rich clients. Most, if not all, of these firms already function on a “best advice" basis and, as such, are not constrained in their choice of financial products.
Nonetheless, legacy, legislative and other related problems will probably limit the take-up of the full-wrap concept. Mr Shields estimates, for example, that assuming the abandonment of the UK’s polarization regime proceeds smoothly the wrap market could be worth “only" £150 billion in 2008 (as compared with the £1,768 billion of potentially wrappable assets currently in existence).
The reality
Perhaps because of these constraints some of the “wrap" initiatives so far unveiled within the UK have tended to mimic the US model. This is certainly the case with the wrap, or separately managed account programme initially launched by Barclays Stockbrokers four years ago. This shared many of the attributes of the Consultant Wrap , although more recently it seems to have evolved into something approaching a multi-discipline account (MDA).
The next UK initiative, made by 7 Investment Management, a firm formed by ex-Barclays Stockbrokers employees also appeared to go down the Consultant Wrap initially. Since then, however, it appears to be adopting a much more holistic, or “full-wrap" approach.
Transact, Hargreaves Lansdowne, and Skandia have also launched initiatives while Abbey and Fundsdirect are both set to enter the market shortly.
Elsewhere, the take-up of full-wraps is expected to be much slower. This stems from the fact that in Europe people tend to deal with a much more focused range of financial institutions.
But as with virtually everything time will tell.
By: Ian Orton, Editor, TheWealthNET (http://www.thewealthnet.com)
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