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A reader recently emailed a question regarding a brokerage wrap account he had inherited from a relative. He mentioned that he was being charged a one percent management or wrap fee and also suspected that he was incurring a front-end load on the A share mutual funds used in the account.

Upon further review we determined that the mutual funds were not charging him a front-end load. Almost all of the funds being used, however, had expense ratios in excess of one percent plus most assessed 12b-1 fees paid to the brokerage firm as part of their expense ratios.

Are brokerage wrap accounts a good idea for you? Let’s take a look at some questions you should be asking.

What are you getting for the wrap fee?

This is the ultimate question that any investor should ask not only about wrap accounts but any financial advice you are paying for.

In the case of this reader’s account it sounds like the registered rep is little more than a sales person who put the reader’s uncle into this managed option. From what the reader indicated to me there is little or no financial advice provided. For this he is paying the brokerage firm the one percent wrap fee plus they are collecting the 12b-1 fees in the 0.25 percent to 0.35 percent on most of the funds used in the account.

Before engaging the services of a financial advisor you would be wise to understand what services you should expect to receive and how the adviser and their firm will be compensated. Demand to know ALL aspects of how the financial advisor will be compensated. This not only lets you know how much the relationship is costing you but will also shed light on any potential conflicts of interest the advisor may have in providing you with advice.

What’s special about the wrap account?

While the reader did not provide me with any performance data on the account, from looking at the underlying mutual funds it would be hard to believe that the overall performance is any better than average and likely is worse than that.

Whether a brokerage wrap account or an advisory firm’s model portfolio you should ask the financial advisor why this portfolio is appropriate for you. Has the performance of the portfolio matched or exceeded a blended benchmark of market indexes based on the portfolio’s target asset allocation? Does the portfolio reduce risk? Are the fees reasonable?

What are the underlying investments?

In looking at the mutual funds used in the reader’s wrap account there were a few with excellent returns but most tended to be around the mid-point of their asset class. Their expenses also tended to fall at or above the mid-point of their respective asset classes as well.

Looking at one example, the Prudential Global Real Estate Fund Class A (PURAX) was one of the mutual funds used. A comparison of this actively managed fund to the Vanguard REIT Index Fund Investor shares (VGSIX) reveals the following:

Expense ratios:

PURAX VGSIX Expense Ratio 1.26% 0.24% 12b-1 fee 0.30% 0.00%

Trailing returns as of 12/31/14:

1 year 3 years 5 years 10 years PURAX 14.03% 14.47% 11.12% 6.66% VGSIX 30.13% 16.09% 16.84% 8.41%

While the portfolio manager of the wrap account could argue the comparison is invalid because the Prudential fund is a Global Real Estate fund versus the domestic focus of the Vanguard fund I would argue what benefit has global aspect added over time in the real estate asset class? Perhaps the attraction with this fund is the 30 basis points the brokerage firm receives in the form of a 12b-1 fee?

Looking at another example the portfolio includes a couple of Large Value funds Active Portfolios Multi-Manager A (CDEIX) and CornerCap Large/Mid Cap Value (CMCRX). Comparing these two funds to an active Large Value Fund American Beacon Large Value Institutional (AADEX) and the Vanguard Value Index (VIVAX) reveals the following:

Expense ratios:

CDEIX CMCRX AADEX VIVAX Expense Ratio 1.26% 1.20% 0.58% 0.24% 12b-1 fee 0.25% 0.00% 0.00% 0.00%

Trailing returns as of 12/31/14:

1 year 3 years 5 years 10 years CDEIX 10.01% NA NA NA CMCRX 13.11% 19.30% 12.98% 5.78% AADEX 10.56% 21.11% 14.73% 7.57% VIVAX 13.05% 19.98% 14.80% 7.17%

Again one has to ask why the brokerage firm chose these two Large Value funds versus the less expensive institutionally managed active option from American Beacon or the Vanguard Index option. I’m guessing compensation to the brokerage firm was a factor.

Certainly the returns of the overall wrap account portfolio are what matters here, but you have to wonder if a wrap account uses funds like this how well the account does overall for investors.

The lesson for investors is to look under the hood of any brokerage wrap account you are pitched to be sure you understand how your money will be managed. I’m not so sure that my reader is being well served and after our email exchange on the topic I hope he has some tools to make an educated evaluation for himself.

The Bottom Line

Brokerage wrap accounts are an attempt by these firms to offer a fee-based investing option to clients. As with anything investors really need to take a hard look at these accounts. Far too many charge substantial management fees and utilize expensive mutual fund options as their underlying investments. It is incumbent upon you to understand what you are getting in exchange for the fees paid. Is this investment management style unique and better? Will you be getting any actual financial advice?

The same cautions hold for advisory firm model portfolios, the offerings of ETF strategists and managed portfolios offered in 401(k) plans. You need to determine if any of these options are right for you.

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