Rather than invest directly in traditional stand-alone mutual funds, a growing number of advisors are choosing to place their clients’ assets in multi-manager portfolio products.

Fund wraps, as the name suggests, wrap a number of investment options into a single package – one that’s tailored to a specific risk tolerance or objective. Instead of pouring over prospectuses and creating a portfolio of funds on their own, advisors who use these “funds of funds” can delegate that responsibility to another manager who also monitors and rebalances the underlying investments. If an advisor has conservative clients who want regular income, he or she just has to choose a conservative, income generating wrap program and buy units on behalf of the client. The fund of funds manager will handle the rest.

It’s an increasingly popular concept. According to research conducted by Investor Economics, fund wrap assets grew at a compound average annual rate of 28.2% from June 2003 to June 2006, while the assets of stand alone mutual funds only increased by 12.4% for the same period. Investor Economics also says that, for the first three quarters of 2006, 65% of net sales went into wrap accounts.

In fact, funds of funds have now become so popular that the Investment Funds Institute of Canada (IFIC) has decided to change the way it reports industry statistics. As of January 2007, IFIC began reporting statistics on fund-on-funds and wrap accounts (see inset table and text on page 28), in addition to statistics on proprietary funds and stand-alone funds.

What’s driving this astronomical growth? Michael Dumond, senior vice-president of Money Concepts in Barrie, Ontario, suggests that demographics have a lot to do with it. He points to members of the baby boom generation who want to simplify their lives as they approach retirement. A fund wrap could provide them with diversified, tax efficient income, and better returns than currently available with GICs, and all on one statement.

On the other hand, he says wraps appeal to the aging financial planners themselves. “They’re getting close to thinking about retirement and trailer fees,” he says. “They want more time but don’t want to give up residuals.”

Time starved advisors

A study published by Vancouver’s Credo Consulting in August confirms that advisors are indeed looking for ways to streamline their businesses. The 1500 Certified Financial Planners (CFPs) surveyed said that time management was the single biggest challenge they faced in their practices. And if an advisor is time starved, one way to free up additional hours is to outsource tasks like investment management to a third party.

“With their built-in due-diligence, model portfolios, risk assessments, rebalancing, and other turnkey features, [wrap programs] offer a way for advisors to download more of their routine activities and focus more time on prospecting and individual client service needs,” reads the Credo report. This is particularly true for planners who work for the banks, 56% of whom used fund wraps, compared the industry average of just 37%.

The product appears to have established a firm foothold in the Canadian financial planning market over the last few years. Credo found that advisors who were already using wraps had allocated nearly a quarter (22%) of all of their client assets to them, and 95% expected to either maintain or increase that proportion over the next one to two years. Since 2004, the growth in wrap usage amongst CFPs has outpaced that of both managed accounts and linked notes.

Compensation and compliance

Besides helping to lighten an advisor’s workload, Geraldo Ferreira, vice-president of investment products development and marketing at Aegon Fund Management and Transamerica Life Canada, says fund wraps can help veteran advisors who want to annuitize and eventually sell their books of business.

Older clients may want fixed income investments, but bond mutual funds only pay about half of the ongoing service fees offered by stock market based mutual funds. An advisor who gives clients the conservative mutual funds they both want and need may end up reducing the selling price of his or her practice. Funds-of-funds, however, can solve this problem. “Regardless of whether it’s a conservative or aggressive model, the trailer revenue from a portfolio is equivalent to an equity trailer,” he says.

Mr. Ferreira suggests that newer advisors stand to gain from managed money products as well, since those who defer asset allocation decisions may be less likely to experience regret during the next market downturn.

“There’s a bit of a hangover from the last bear market. Every major stock market took a long steady drop for two to three years,” he says. “It ravaged a lot of peoples’ investments.” In some cases, inexperienced advisors who made their own fund choices may have put too large a portion of their clients’ assets into equities. While an investor who held a managed money product wouldn’t have been immune to market fluctuations, Mr. Ferreira does think that clients in wraps might have been insulated from overly aggressive recommendations.

Higher Fees

“Compliance and management love this,” says Norbert Schlenker, a fee-for-service investment manager in Salt Spring Island, British Columbia. “It’s difficult for advisors to do stupid things if they use products like this. They are less likely to blow up a client.”

He is, however, very skeptical about the product’s value to the consumer. Mr. Schlenker agrees that wrap products may free up time for advisors so that they can do other useful things such as tax planning and estate planning. However, he believes the two-and-a-half to three per cent management expense ratios (MERs) typical of funds-of-funds is an exorbitant price to pay for convenience, especially in the case of larger accounts.

Adding another management structure on top of funds, which already charges fees of their own means that money has to work even harder to meet or beat the return of the benchmark index. That’s something many stand alone mutual funds already have a hard time achieving. “I think clients are giving an awful lot away,” he says.

Stephanie Venn, a portfolio manager with Nilson and Company in Vancouver, shares this concern about high fees in fund of fund accounts. “When advisors are selling funds of funds, are they disclosing exactly what the client is paying?” She says that not only are there the MERs of each underlying mutual fund to consider, but if a fund is holding trusts there are fees buried in those vehicles as well. “Do clients have a clue as to what they’re paying as far as management fees?” she asks.

Mr. Ferreira says that the additional costs can be justified. “Yes, the extra MER is worth it in the sense that you have a well constructed portfolio,” he says. “There’s a fair amount of due diligence involved, and fund companies do both quantitative and qualitative research to determine which funds meet criteria for inclusion.”

Since the product is relatively new, and since neither Morningstar nor Globefund track funds-of-funds as a separate category, it is difficult to determine if most wraps are earning their keep and delivering above average performance. It may be that clients purchase professional management through funds-of-funds, even if it costs more in fees, because it allows them to overcome a psychological hurdle.

Not long ago, Mr. Schlenker says he spoke to a prospect who had $1 million invested in actively managed mutual funds. He would have suggested a portfolio made up mostly of exchange traded funds, all with very low MERs, which would have reduced the investor’s annual management fees from $25,000 to about $2,000 a year. The prospect went to one of the big brokerage firms and bought a wrap account instead. “I believe that decision will cost him 2.5% a year, and over twenty or thirty years time he will end up with less money,” says Mr. Schlenker. “But the fact he didn’t have to write a cheque (to a planner) was more important to him.”