Although wrap programs have gained favour among Canadians, their structure, payouts, fees and performance have ignited a debate about whether they serve clients’ best interests.

Canadian investors purchased $16.2 billion in net new funds of funds in 2007, up from $9.6 billion in 2006, according to the Investment Funds Institute of Canada.Net new money for stand-alone funds, meanwhile, reached $10.4 billion for 2007, up from $9.9 billion the previous year.

Since the beginning of 2006, when IFIC began tracking funds-of-funds sales, there has yet to be a single month during which net sales were in negative territory.

A study by Toronto-based In-vestor Economics Inc. found much the same thing. Its Retail Brokerage Report says fund wraps have been “the hot growth pocket” on the financial advisors’ shelf, with double the growth of overall assets under management during the past two years.

But while ease of selling and higher payouts make wraps attractive, some advisors question the value of wraps. Fees, overdiversification of portfolios, the funds packaged in the wrap and performance are all bones of contention.

Wrap programs first hit the Canadian marketplace in the mid-1990s. There are two main types of wraps: traditional wraps, which offer a full range of securities and are overseen by expert managers; and mutual fund wraps, which do essentially the same thing but with funds instead of stocks.

Fund analyst Dan Hallett, president of Dan Hallett & Associates Inc. in Windsor, Ont., says wrap programs essentially take the balanced fund category and add a number of features — including a questionnaire to determine which portfolio is best suited to a particular client — as well as enhanced reporting.

“You’re buying a diversified portfolio in a single purchase,” he says, “which is the same concept as a standard balanced fund.”

BROAD DIVERSIFICATION

Larry Herscu, senior vice president of Toronto-based AGF Funds Inc., which offers both the Harmony and Elements portfolio programs, says wrap programs provide broad diversification, and clients like the fact there’s a discipline to the asset-allocation mix.

Herscu attributes the popularity of these programs to the “sleep well at night” factor. “Clients tend to want to buy things when they’re going up and sell them when they’re going down,” he says. “Wraps take out the emotion and help clients do the right thing when, intuitively, they don’t want to.”

There are now more than 130 wrap products in the market, he adds, with AUM of more than $350 billion — almost half the size of the mutual fund market.

But just because wraps are all the rage doesn’t mean they’re necessarily the best option for clients. Steve Norton, vice president of Winnipeg-based Value Partners Investments Inc., likens wrap programs to cable-TV packages containing a select few channels you want to watch and a bunch more you don’t.

“If you’re a sports fan, you probably have a package with cooking channels and home and garden channels,” he says. “Eighty per cent of your enjoyment probably comes from five or six channels. That’s what a wrap program is.”

This is one of the criticisms of wrap accounts: they often package top-selling funds with the black sheep of the fund family. “You could certainly find some examples of funds being stuffed into [wraps] that might not otherwise get net sales,” Hallett says. “I’ve seen new products launched by various companies and, shortly after, they’re added to the companies’ wrap program. The optics of it aren’t that great.”

Overdiversification is another criticism. It’s no secret that the most successful investors, such as Warren Buffett, have concentrated portfolios with just a handful of positions. But as Norton points out, the vast majority of retail investors, on the other hand, employ the exact opposite approach.

“The reality is most people have anywhere from five to 20 mutual funds, and each fund has an average of about 100 stocks. There’s a ton of overlap,” he says. “For what you’re paying to get that kind of diversification, you should buy an index fund.”

But Erin Griffiths, director of fee-based programs at Toronto-based ScotiaMcLeod Inc. (which has about $4 billion in AUM in its Pinnacle program and the Sovereign program offered by Russell Investments), says Scotia-McLeod’s high-end wrap programs differ significantly from index funds in that they have active managers who take a disciplined approach to buying and selling their holdings.

@page_break@“They’re certainly not passive strategies at all,” she says. “They are obviously popular with advi-sors. We’ve had 25% growth in these programs in previous years.”

LESS THAN 6%

The pools typically have 10 to 12 funds in a well-diversified portfolio, with each fund holding “in the hundreds” of equities, Griffiths says. The price paid by clients depends on their investible assets, with fixed-income fees ranging from 0.5% to 1.25% and equity fees running between 1.25% and 2.5%.

Norton also finds wrap returns lacking. The best-performing wrap accounts have an average annual compound return of less than 6% over the past decade, vs 9% for the S&P/TSX composite index.

Hallett agrees: wraps’ overall performance has been “disappointing,” he says. He partly blames fees that average about 2.5% — about 50 basis points higher than for standard mutual funds.

“There are still wraps that are in the 3% range,” he says, “and the odd one that’s above that.”

But wraps are popular because they’re easy to sell, they provide a diversified portfolio by manager, style and geography, and they’re monitored by analysts worldwide, Norton says. Combine that with the endless number of mutual funds available and the never-ending knocks on the door from wholesalers, and it’s no surprise advisors are turning to wraps in greater numbers. “[Using wraps] is a non-decision,” he says.

Hallett also notes that in many cases, advisors receive higher payouts for selling wraps. “It’s not across the board,” he says. “But certainly there are a number of wrap products that pay out more than 1% a year in trailers and as much as 1.5%.” (Most stand-alone funds pay out about 1%.)

There will always be advisors who sell products because of higher payouts but, Hallett adds, the popularity of wraps is based on the ease with which they enable advi-sors to introduce a disciplined process to their practice. IE