The Asset Management Maze

It was just about a year ago when I completed my first look at the popular wrap or asset management programs. I focussed on the myths of wrap programs and really made fees the focus of the research. In this report, I hope to revisit some of the popular myths, the after-tax fee issue (in light of the October mini-budget), and what the various programs offer its participants.

Wrap or asset management programs are so called because they take the package of investment management and administrative services, bundle them together and charge one all-in fee for the whole ball of wax. In one form or another, such programs have profiling questionnaires to determine the investor’s objectives and constraints. Based on the resulting profile, the investor is assigned a "model portfolio". That’s the general description but the programs come in many different shapes and sizes. There are three general types of wraps.

Wrap programs are defined by the investment product used to design the portfolio. Mutual fund wraps simply take existing retail mutual funds, collect the trailer fees from those funds, and charge a fee on top of the underlying fund management expense ratios (MERs). These programs include Scotia Leaders, TD Map Portfolios, CIBC Choice Funds, Keystone (M.R.S. Trust), Mackenzie’s STAR, etc. These programs typically don’t produce any type of written plan or investment policy statement. That is left to the individual advisor dealing with the prospective client. The minimum investment in most of these programs typically ranges from $2,500 to $5,000. Generally speaking, this is the simplest type of wrap program because it often comes in the form of a fund-of-funds approach. In this category, the products offered by banks are the most costly since they usually use only load funds and charge a generous fee on top of fund MERs. Keystone stands out as the best in this class.

Rather than retail mutual funds, these programs use pooled funds – which are basically lower cost mutual funds. While pooled funds usually carry lower costs than mutual funds, the wrap programs that use pooled funds are usually more costly than a portfolio entirely composed of load mutual funds. Some programs may provide investors with a detailed investment policy statement and just about all generate more personalized performance reporting – including performance versus appropriate benchmarks. Minimum investment requirements range from $10,000 to $100,000. While investors typically enjoy a higher level of service and reporting, it comes at a steep cost.

No I’m not talking about the insurance company funds with capital guarantees and creditor protection. I’m talking about "individually managed accounts" which are commonly known as "segregated accounts" and involves the direct ownership of securities, rather than the indirect ownership through an investment fund. These come in two forms.

The seg accounts with which most people are familiar are those marketed directly by brokerage firms. The broker signs management agreements with money managers or investment counsellors to be part of their program. Since the financial institution does big volumes, they negotiate lower initial investment amounts (~$100k) than could otherwise be arranged. A typical client in these accounts would have between $250k and $750k and be spread out among a few different managers. The managers would then buy stocks, bonds, and other securities directly for the client’s portfolio. The fees aren’t cheap, ranging from 2.0% to 3.0% (lower for larger amounts) but they usually include all transaction costs or a specified number of trades per year – unlike mutual or pooled funds. A 2.0% fee for a seg account is equivalent to a mutual fund MER of 1.5% to 1.7%. (Very roughly, transaction costs on a typical fund portfolio would run 0.3% to 0.5% annually.)

In its simplest form, a seg account can be set up directly with a money manager or investment counsellor. The minimums to go direct to a money manager usually start around $1 million and can range as high as $50 million or higher. (The latter threshold is more applicable to charitable foundations, pension funds, or other institutions.) While the minimum is often $1 million, it is usually advisable to look at this option only for portfolios of $5 million to $10 million in order to have proper style diversification and the ability to choose multiple managers based on their areas of specialty. Fees are typically half of the broker-sold seg accounts, but ironically the managers are often the same. While traditional wrap programs bundle together the fees, this type of seg account completely unbundles the fees, which are broken down as follows (with estimates of typical annual fee percentages in brackets):

0. Investment management fee (0.50% to 1.25%);

0. Custodial and trustee fee (0.05% to 0.20%);

0. Trading (borne by the investor but usually falls around 0.30% to 0.50%);

0. Total fees of 0.85% to 1.95% annually.

A report could easily be dedicated to each type of asset management program. However, both parts in this series of articles will focus on the type that tends to be most heavily marketed - Pooled Wrap Programs. These include programs like AGF Harmony, CI Insight, Dynamic Viscount, Merrill Lynch Frontiers, Optima Strategy (Assante), Opus2Direct, and Frank Russell’s Sovereign program. Others exist but this report will focus on those mentioned.

These programs sometimes employ outside managers or a combination of internal and external, but they all have one thing in common: relatively high fees and a lack of customization. However, in evaluating any professional service, the focus should be in comparing what you get with what you pay.

There are a few common things you get with almost any wrap program. All programs will do some profiling of investors. The profile results in the client being boxed into a "model portfolio". However, the clarity with which objectives, risk, and constraints are quantified varies widely. Most of these programs will look more at risk attitudes and qualitative return expectations (i.e. growth, income, safety, etc.) rather than hard numbers. The model portfolios are usually based on some type of optimization model whereby the portfolios exhibit an optimal amount of return (based on historical return) given the level of risk taken (as measured by standard deviation – the average amount by which monthly portfolio returns move about its average). This method has two weaknesses. First, its focus on historical returns is not forward looking. Those that do try to project future return levels and ranges usually do so based on historical average returns and standard deviations. Since standard deviations vary widely over time, the projection is subject to a significant margin of error. However, I give those programs credit for not simply defaulting to past performance. In the Frontiers program, Merrill Lynch projects future returns based on past experience since 1970, but adjusts return projections downward to reflect their reduced expectations of the future. Second, the use of standard deviation is less than ideal. While standard deviation is useful in a modeling environment, it is not a good risk indicator since it counts upward volatility as risk. A downside deviation or some other risk measure isolating downside volatility is more indicative of what most investors define as risk.

Most programs will draft an investment policy statement (IPS) detailing the investor’s objectives, constraints, portfolio recommendations, some general information on portfolio design, and methodology. However, the depth and quality of the various IPSs varies widely from the plain vanilla version offered by Dynamic’s Viscount program, to the more comprehensive Frontiers IPS prepared by Merrill Lynch. Others simply don’t include this in the standard package of services for which investors pay, leaving written proposals up to the individual advisor.

Almost all programs include ongoing monitoring and portfolio rebalancing as market values fluctuate. However, that’s not the case with all programs. Optima Strategy is the standout in this regard since it charges additional fees to monitor client accounts and implement regular rebalancing.

In order to get an optimized portfolio, presumably a big part of that is matching up styles that are complimentary to improve the risk/return relationship. Also, many programs boast of the fact that they offer access to managers that would otherwise be untouchable to most retail investors. To some extent this is true but most of the money managers available through pooled fund wrap programs are just as accessible to retail mutual funds. Beutel Goodman, Brandes International, Guardian, McLean Budden, Mulvihill Capital Management, Standard Life, and YMG are just a few of the featured money managers of many wrap programs and are widely available through retail mutual funds.

While some programs make extensive use of external managers (like those mentioned above), others simply use internal managers. For example, every component of CI’s Insight program features a manager found in CI’s own retail mutual fund lineup. So all you’re getting with Insight is profiling and monitoring – something most investors expect from their advisors anyway. Until recently, Optima Strategy didn’t even make much use of style diversification. Winnipeg-based Loring Ward Investment Counsel (which, along with Optima strategy, is under the Assante umbrella) uses a strict value style, but only recently introduced the Optima Strategy Partners funds, which feature many familiar names on the retail scene – such as AGF, AIM, BPI Global Asset Management, and CI Global Advisors. Merrill Lynch and Dynamic also run a good chunk of the money in their respective wrap programs, while using some external managers for style diversification.

One aspect that I found quite interesting was Dynamic’s inclusion of indexing in its Viscount program. Dynamic has State Street Global Advisors managing about 30% of the equity money (Canadian, US, and overseas equities) using an indexing approach. While this sets Viscount apart from its peers, it also sends a clear message that Dynamic won’t risk underperforming equity benchmarks. Then again, it probably means they won’t have much of a chance to outperform by much either.

RBC Dominion Securities had boasted for years that its Sovereign wrap program was unique in its use of Frank Russell Canada (an independent third party) to monitor their program’s managers for performance and adherence to style. (In actuality, Sovereign is Frank Russell’s program and RBC has simply had exclusive distribution rights for many years.) Given that some programs include internal managers, an independent third party seems like a valuable component. In other words, if Merrill Lynch’s growth style was underperforming, there is little chance that they’d take themselves off the job. While Sovereign was long exclusive to RBC, that exclusivity has recently ended. As a result, we’re likely to see Frank Russell distributed by other dealers. In fact, one announcement has already been confirmed. By the time this article is published Sovereign will be distributed through a second dealer - TD Evergreen. As new wrap programs have been introduced over the past couple of years, most have contracted third party consultants to do manager monitoring and style adherence.

Okay, we’ve talked at length about what investors get with wrap programs but we’ve spent little time on costs. There are a few issues to address. First, these programs are just too expensive. Compounding that problem are the aggressive marketers of such programs, who downplay the actual cost by boasting of the tax deductibility of the fee if billed directly to the investor. Table I below details the fees for various asset classes, in addition to operating expenses and other applicable fees. There are a few things worthy of note.

Though not always specific, all programs have negotiable fees for the right amount of money. However, that would require at least $250,000 – a level that often requires a more customized approach than that available in such programs. Financial advisors or brokers who sell these programs usually have the discretion to lower fees by a certain amount, with the wrap sponsor and the advisor often splitting the discount. Any discount beyond a certain amount usually comes completely out of the advisor’s pocket.

Most would think an investment program targeted at larger portfolios ($50k to $100k) would benefit from some economies of scale. Not so with pooled wraps. To get a closer look at the component costs of wrap fees, Table I breaks down the total fees (including GST) that apply to each asset class. In two cases, there are fees in addition to the standard management fees and operating expenses.

Sovereign investors pay a record-keeping fee of 0.02% of the portfolio value directly to the distributor - RBC Dominion Securities, TD Evergreen, etc.

As mentioned earlier, Optima Strategy clients only get their portfolio monitored and rebalanced if they pay an additional fee - as do 85% to 90% of Optima clients. Signing up for their Asset Management Service does entitle the investor to an investment policy statement and a break on the management fees otherwise payable. The asset monitoring fee is 0.90% plus GST. The offsetting break on management fees results in investors effectively paying an additional 0.6% to 0.7% each year just to have the portfolio monitored on a regular basis - something that all other programs already include for substantially lower fees. This, along with the fact that Assante advisors can sell Optima funds on a deferred sales charge basis, is what makes this a prohibitively expensive asset management program.

Table II below takes the component costs of each program and illustrates the fees payable on a more typical balanced portfolio in each program. Also included is a comparison of the popular wrap programs to retail mutual funds and a list of the additional services provided. It is worthy to note that most mutual fund portfolios are likely to be cheaper than comparable wrap programs.

Aggressive marketers of wrap programs will usually downplay the level of fees involved by boasting of the tax deductible nature of fees invoiced directly, contrasting it with the "deducted-at-source" nature of mutual fund fees. That’s probably the biggest myth alive with respect to such products. The fees are tax deductible, but not in all cases and not always the full amount of the fee.

For instance, if a program includes some services other than investment counselling or administrative services, part of the fee may not be deductible. There is a provision in our tax laws (paragraph 20(1)(bb)) that allows individuals to deduct fees paid for advice on buying or selling securities and other administrative functions with respect to such securities (i.e. custodial services). However, if your wrap management agreement details advice on legal issues, estate planning, or general financial planning, you’ll find a portion of your wrap fee is not deductible. Further, once you’ve figured out what portion of the fee is attributable to services detailed in paragraph 20(1)(bb) of the Income Tax Act, you then must prorate the fee to the proportion that is attributable to your non-registered account. For instance, let’s say you pay $6,000 this year for investment counsel fees and your portfolio is 2/3 in RRSPs and 1/3 in a regular taxable account. In that case, only 1/3 of your total fee (or $2,000) is deductible against other income in the year.

For simplicity and for comparison purposes, let’s assume for a moment that all wrap fees that are invoiced directly and are deductible. Does the direct billing of management fees provide a tax-related benefit over conventional mutual funds? Yes, but the advantage is so small it’s not worth bragging about. Further, it is really dependent on the amount and type of investment income generated by the portfolio. The less income generated overall, the more advantageous direct billing is for the investor. However, most investors get a balanced portfolio, which generates a mix of interest, dividends, and capital gains each year.

Table III illustrates the experience of two investors - one in a wrap account with direct billing of management fees and the other invested in an otherwise identical mutual fund portfolio. Table III should demonstrate that the tax deductibility of wrap management fees really isn’t much different than the "at source" method of charging mutual fund management fees. There are a few items of which to take note.

Notice that the ending value of the wrap investors is quite a bit higher than that of the mutual fund investor. Why? Because the direct billing of management fees leaves more money in the portfolio to grow. Mutual funds calculate and credit the management fee daily so the liability grows each day, reducing the net asset value. While this seems like a point against mutual funds, it actually results in a lower dollar amount of fees paid for the mutual fund investor. Also, while the wrap fee provides a healthy tax deduction, that investor also has substantially more taxable income to claim on his tax return. The bottom line: in this hypothetical scenario, the wrap structure provides a net after-tax benefit of 0.17% per year - all of it attributable to the difference in tax treatment. This figure is slightly higher (by 0.02 percentage points) from a year ago, when the capital gains inclusion rate was 75%. This net advantage in favour of the wrap assumes identical fees. However, we’ve already seen in the tables above that fees on wrap accounts can often be substantially higher in many cases - thereby wiping out any after-tax fee advantage.

There is a tax advantage with some of the pooled funds in these programs but ironically, it’s not the heavily marketed one regarding tax deductible fees. Rather, the accounting systems that many of these pools use results in a higher level of tax efficiency for investors. Before getting into that, it may be useful to quickly review the main tax inefficiency with most investment funds.

All pooled investment products (like mutual funds, segregated funds, exchange traded funds, etc.) have a built-in tax inefficiency. Essentially, you could end up paying the tax bill on gains in which you didn’t participate during the time invested. While it’s not double taxation per se, distributions often result in a prepayment of taxes. To illustrate this point, let’s consider a hypothetical fund that holds $1 million in assets at the end of 2000. Also suppose:

0. the fund has risen in price over the past five years from $5 to $10 per unit, thanks to the rise in price of its stock holdings; and

0. you made a $1,000 investment - 100 units or 0.1% of the fund - before year’s end.

During 2000, let’s say the fund had sold all of its stocks - realizing a gain of $5 per unit. The fund must then pay out that gain of $5 per unit, which equates to $500 for your account ($5 x 100 units) or an additional 100 units if reinvested.

The bottom line here is that you invest 100 units at $10 each ($1,000). Also recall that upon paying a distribution of income, the fund’s assets decrease by that same amount since the fund is actually paying out cash. At the end of the year, you’re left with 200 units at $5 each ($1,000) and additional taxable income of $500. In other words, you’ve prepaid a good chunk in taxes and your total value is still anchored at $1,000.

So where’s the benefit? Some wrap programs have accounting systems that more equitably credit and distribute taxable income to unitholders. For example, Sovereign’s pools will actually pay out distributions to departing unitholders, an amount of taxable income that is attributable to the units being sold. In other words, even if the unitholders aren’t around at year-end (typically when funds pay out distributions) departing unitholders take their portion of the fund’s taxable income with them, leaving less taxable income to be distributed to remaining unitholders at year-end. Optima Strategy also has a similar accounting system which credits taxable income based on the amount of time invested.

So yes, there is a tax advantage with pooled funds and the "wraps" that use them, but it’s got nothing to do with fees. Incidentally, other pooled funds that aren’t in any wrap program, like Sceptre’s SPIF funds, have been using such an accounting system for some time. Hence, we’re likely to see more and more firms implement similar systems for their retail mutual fund offerings.

Let’s face it, any program or product that comes prepackaged and that has a computer doing much of the work has limitations. In the case of wraps, most don’t fully consider the remainder of your portfolio. Sure they do some analysis on your current portfolio, but they don’t deliver customized solutions. Let me give you an example.

Joe has a $100,000 non-registered mutual fund portfolio with accrued (i.e. untaxed) capital gains of $40,000. He also has a RRSP worth $100,000 that he wants to invest in a wrap program. Instead of a customized service, most simply offer products. Rather than examining the content of the non-registered mutual fund portfolio (i.e. types of stock exposure - financials, energy, technology, etc.) and offering advice on restructuring that portion, wrap programs will simply recommend one of their "model portfolios". I don’t know of any asset management product that offers the customization that portfolios of this size deserve. To further illustrate the point, individuals with generous defined benefit pension plans could already be considered to be heavy into fixed income since the investment risk in such plans lies with the plan sponsor, not the individual. Advisors may be able to account for this but the programs’ ability to exactly adjust for this may be limited since fixed model portfolios tend to be used for each investor type.

My recommendation is for investors to stay away from these programs altogether since the advantages are outweighed by the negatives, in my opinion. If you’re paying an advisor for personalized advice, s/he should be qualified to perform the services promised by wrap programs. Advisors who use wrap programs for "everybody" are simply trying to reduce their workload. Though some programs’ costs come in under 2%, consider the fact that a hybrid approach that uses regular mutual funds and other low-cost products (i.e. exchange-traded funds, bonds, etc.) can provide investors with a very well diversified, tax-efficient, and low-cost portfolio and provide ample compensation for your advisor. A proposal I worked on recently was for a seven-figure portfolio that used this same type of hybrid approach. Total costs amounted to an all-inclusive 1.12%.

However, if the package of services offered by some wraps remains appealing, Sovereign offers the best value for investors, in my opinion. A solid list of managers, good style diversification, manager monitoring which is independent from the managers, recently reduced costs, and a tax-efficient structure add up to some good benefits (though I still think the price is steep for most with larger portfolios). A problem with Sovereign in the past was the fact that it was only offered by one firm and couldn’t be transferred by investors who wanted to take their business elsewhere. Now, with the addition of TD Evergreen and the likelihood of adding more dealers to their distribution in the near future, this issue may no longer be a problem.

Later this year, I’ll revisit this issue with a focus on the more appealing individually managed accounts and investment counselling firms.