That's a Wrap

What are the pros and cons of wrap accounts?

Wrap accounts are essentially the all-you-can-eat buffets of the investing world. For an annual fee that typically ranges from 1% to 3% of the assets you have under management, you can trade as much as you like and often have helpings of tasty sides such as investment-research and financial-planning services.

The major benefit of wrap accounts is that the money manager has a vested interest in your portfolio's growth, rather than in making trades just to generate commission, says Brian Kistler, a senior vice president for investments at financial-services company Raymond James. "The rationale behind it is to get the client and the adviser on the same side of the table," he says. In other words, when your broker or financial adviser calls you with a hot tip, you can feel comfortable knowing that he isn't pushing the stock simply to line his own pockets. With this arrangement, in order for the broker to do well, you need to do well.

A more cynical view is that wrap accounts provide a steady income stream for brokers during both up and down markets. While some investors choose to sit on the sidelines during a bear market, brokerages that offer wrap accounts collect their fees, albeit smaller ones, regardless of how actively investors trade. Indeed, this feature makes wrap accounts a poor choice for buy-and-hold types in any market. Those who like to buy a bunch of bonds or mutual funds and let them sit for years are better off with a commission-based broker, Kistler says. Otherwise, "they'll be paying a fee every year for someone to sit there and watch their accounts," he notes.

Most brokerage houses and many financial planners offer wrap accounts, although they vary dramatically based on minimum investment requirements, fees and services rendered. At their most basic, a wrap account is simply an alternative to commission-based payments. More sophisticated (and expensive) wrap accounts come with active portfolio management.

No matter which types of services are provided with the account, however, investors need to keep a careful eye on fees. Unfortunately, they're often too high to make wrap accounts attractive — particularly for investors who don't have a large sum to invest, and thus miss out on any kind of high-roller discount. For example, some basic wrap programs have minimums as low as $10,000, but you'll be charged a whopping 3% fee for the service. So if your portfolio gains 8% in one year, you'll be giving back almost half of it in fees. And if your portfolio loses money, well, you can do the math.

In addition to the bare-bones, commission-replacement wrap accounts, here's the lowdown on two common types of actively managed wrap accounts offered by many brokerages.

Mutual-Fund Wrap Accounts
As the name suggests, these are wrap accounts made up entirely of mutual funds. They differ from basic commission-replacement accounts in that the investor relinquishes control over his or her portfolio to the adviser. (The portfolio will be allocated based on feedback from the investor regarding goals and risk tolerance.) The adviser then reviews the portfolio on a regular basis, adjusting it when necessary. These programs appeal to those looking to hand over the reins of their portfolios, says Sarah Libbey, a senior vice president at Fidelity Personal Investment.

At most brokerages, investment minimums are around $25,000, but they can be as low as $10,000. Typically, the more you invest, the lower the percentage you'll be charged as a fee. For example, with Fidelity's Funds Manager Program, you'll be charged 1.10% of total assets if you invest $50,000 (the minimum), although this drops to 1% if you can pony up $200,000. The fee continues to fall with each additional $100,000 invested.

A cheaper (albeit less sophisticated) option would be to invest instead in a so-called "fund of funds." These are funds that incorporate diversification into a single share by investing in other funds — and their expense ratios can fall below 0.5%. The trade-off is that funds of funds are generic — they're allocated broadly to suit large swaths of the investing public, rather than a specific individual's needs. Still, they can make a lot of sense for cost-conscious investors. For our latest picks, see our story.

Third-Party Manager Accounts
Unlike mutual-fund wraps or the basic commission-replacement programs, these accounts (also known as separately managed accounts) are managed by a third-party money manager selected by the investor's financial adviser or the brokerage house's financial consultants.

The money manager controls the account, which can hold any type investment, although the investor can put certain restrictions on the type of funds in it, such as avoiding tobacco stocks, says Kim Landry, vice president at A.G. Edwards. Unlike a passive mutual-fund wrap account, third-party managed accounts allow the manager to go out and buy and sell individual investments based on your needs, Kistler says.

The minimums for these accounts are higher, since they target more sophisticated, higher-worth investors. Smith Barney's Separate Accounts program, for example, has a $100,000 minimum with fees maxing at 3%.