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Mutual-Fund Blues? Try a ‘Wrap’

These accounts can hold off the taxman

Moritza Day started investing in mutual funds a decade ago, accumulating a nest egg of nearly $300,000. But the funds’ unavoidable taxable distributions have always rankled Day, a CPA and president of Houston-based financial headhunting firm Day West & Associates. »When you get those 1099s every January, it seems like you’re getting hit with taxes on money you never see,» says Day, who, like most fund shareholders, reinvests her distributions.

So this year, says Day, »I figured there has got to be a better way.» Her answer: a separately managed account, often known as a »wrap.» For one fee, wrap accounts combine the costs of investment counseling, portfolio management, brokerage commissions, and administration. Of course, you could get a similar result by investing in mutual funds with a financial adviser. What’s different in Day’s case is that her money is invested in individual stocks. She will pay capital-gains taxes only when she sells a stock at a profit, not when a mutual-fund manager unloads a holding bought long before she came to the fund. Day reckons that if she had a separately managed account last year, she would have netted $10,000 more after taxes.

NEGOTIABLE. Day isn’t the only investor switching from mutual funds to the separately managed format. While fund inflows are sagging (BW—June 28), the wrap business is booming. Total assets in managed accounts jumped from $163 billion in 1996, to $321 billion at the end of 1998, says the Money Management Institute. Some 30% of the assets are in wrap accounts that use mutual funds, but those don’t offer the customization and tax efficiency of accounts comprising individual securities. Five giant firms—Merrill Lynch, Morgan Stanley Dean Witter, PaineWebber, Prudential Securities, and Salomon Smith Barney—hold about two-thirds of the wrap accounts. But increasingly, smaller brokerages and independent advisers are offering the accounts, as well.

Wrap costs are dropping, making the accounts more competitive with mutual funds. In the early 1990s, wraps charged a steep 3% of assets annually, and that’s still the list price at many brokerages. But rates are negotiable—and in any case, the more you invest, the lower the fee becomes (chart). Thanks to better software and portfolio management systems, investment managers who normally take institutional accounts in $5 million chunks are also more willing to run wrap portfolios as small as $100,000.

CHEMISTRY. Today’s plumper portfolios are also prompting investors to seek help. »Something happens when the portfolio goes from five figures to six, or six figures to seven,» says Steve Gresham of the Gresham Co. which advises firms serving affluent investors. »Even people who didn’t seek advisers before, usually seek advice then.»

Not all asset-based fee programs are wraps. Big brokerage firms also offer annual asset-based fees as an alternative to charging commissions on each trade. Those fees are generally lower than wrap charges, and the accounts don’t offer the same services.

You will find wrap accounts under a slew of names, such as Merrill Lynch Consults or Schwab Managed Account Connection, and each has varying features. But Cerulli Associates, a financial-services industry consultant, says all wrap programs have common characteristics (table). The focal point is a financial adviser or consultant. Choosing an adviser with whom you can communicate easily is critical to the program’s success. »Experience shows client satisfaction really depends on the adviser,» says William Turchyn, chief operating officer at Furman Selz Capital Management, which manages about 5,000 wrap portfolios.

A wrap adviser will assess your risk tolerance and investment goals. Asset-allocation specialists in the brokerage’s support group, such as Salomon Smith Barney Consulting Group or Lockwood Financial Services for independents, review your profile. The adviser will recommend an asset allocation and one or more investment managers to implement it. The support organization monitors your portfolio and through the adviser may suggest adjustments.

PERSONALIZED. While potential tax savings make separately managed accounts attractive, the programs are not tax dodges. If you have a taxable account, you will get hit with a capital-gains liability if your manager sells a security at a profit—which you hope happens. David Brooks, an Indianapolis roofing contractor, says his manager has taken profits in about 5 of his 26 stocks since January, and those will be taxable unless he has offsetting losses. Even so, »I’d rather pay taxes on my gains than someone else’s,» says Brooks, who like Day was bothered by mutual-fund distributions.

The other advantage with a separate account is that you can request tax-related trading. If you have a large profit outside the wrap account, you can ask your portfolio manager to take losses to offset the gain. Likewise, if you have other losses, you can ask a portfolio manager to take selective gains.

A separate wrap account can meet other needs that mutual funds can’t. That’s what financial adviser Lynn Mathre, president of Asset Management Advisors in Houston, has found. She has clients who are Compaq Computer Corp. executives, with substantial holdings in their company’s stock, which they can’t or don’t wish to sell. To offset that risk, Mathre asks her wrap-account portfolio managers not to invest in Compaq and to tread lightly in the computer sector, as well. »You can’t do that with a mutual fund,» she says.

HANG ON. Moving from stocks or mutual funds into a wrap program can be tricky. If your portfolio includes stocks or funds that have ballooned in value, selling them in one swoop can trigger a large capital gain—just what you are trying to avoid. Advisers may work out a plan to liquidate holdings over time so as to minimize the tax impact and shift the cash to investment managers to start anew. Some firms will take a portfolio of securities or funds and do that for you.

You don’t have to kiss all your mutual funds goodbye. Some advisers suggest investors hold on to global funds, since they’re often the best way to put foreign investments in your portfolio. And funds you already have in an individual retirement account or similar plan may not need to be moved. The account is sheltered from taxes, so distributions won’t swell the tax bill. But if you want a customized investment approach and worry about getting slammed with taxes, wrap accounts make a compelling alternative.

BY JEFFREY M. LADERMAN

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