ALI-ABA Course of Study Investment Adviser Regulation. January 26, 2007 Washington, D.C. WRAP Fee Programs: New Challenges in a Familiar Framework

Transcription

1 325 ALI-ABA Course of Study Investment Adviser Regulation January 26, 2007 Washington, D.C. WRAP Fee Programs: New Challenges in a Familiar Framework By Michael B. Koffler Sutherland Asbill & Brennan LLP Washington, D.C.

2 326 2

3 327 I. INTRODUCTION A wrap fee program is one in which portfolio management, brokerage execution, clearing, custodial and other administrative services are provided for a single charge, known as a wrap fee. Often called managed accounts, separately managed accounts or mini accounts, wrap fee programs raise a number of unique regulatory issues due to the interaction of the investment advisers, broker-dealers, custodians and other financial institutions involved in structuring and operating these programs. A. The Sponsor 1 The sponsor of a wrap program typically is a brokerage firm or a bank. The sponsor puts together the group of services and service providers that comprise the program and, typically, makes it available to clients. Among other things, the sponsor is generally responsible for: Client contact; Marketing; Portfolio manager research, monitoring and hire/fire; Certain trade execution; Account statements; and Administration functions. In a traditional wrap fee program, representatives of the sponsor frequently perform the following functions: Initiate and maintain much of the relationship with the advisory client; Certain suitability assessments such as whether fee-based programs generally are suitable and whether a specific wrap fee program is suitable; Assist a client in articulating investment policies, goals and risk tolerance; and Make recommendations among various investment options made available through the program. 1 Traditionally, the Securities and Exchange Commission ( Commission ) has not viewed the sponsor s asset allocation or portfolio manager selection advice as incidental to the brokerage transactions initiated by the portfolio manager and executed by the sponsor. Accordingly, the Commission has viewed broker-dealer sponsored wrap fee programs as being subject to the Advisers Act. See, e.g., Disclosure by Investment Advisers Regarding Wrap Fee Programs, Advisers Act Release No (Jan. 13, 1994). The Commission recently reaffirmed its interpretation that portfolio manager selection and asset allocation services involved in wrap fee programs are advisory services that are not solely incidental to brokerage services. Certain Broker-Dealers Deemed Not To Be Investment Advisers, Advisers Act Release No (Apr. 12, 2005). WO

4 328 In performing these functions, such representatives frequently interview the client, have clients complete questionnaires, analyze client responses, prepare an asset allocation proposal, assist in the selection of the portfolio manager(s) that will manage the client s assets or mutual funds, exchange-traded funds or other options made available through the program, review the client s account and monitor the asset allocation and performance. Some wrap programs, often called discretionary programs, give clients the option to authorize the sponsor to exercise complete or partial discretion for selecting portfolio managers, automatically rebalancing the client s assets among existing investment choices and making other changes. Certain portfolio management programs may be designed to offer certain inhouse account executives as portfolio managers, granting each of them sole discretion to purchase and sell individual securities. In such cases, portfolio manager review committees are often prudent to evaluate such things as the candidate s stated investment strategy(ies), investment process, diversification and risk management strategies, prior investment experience, performance returns and dispersion, strategies for allocating investment opportunities and execution fills. B. The Portfolio Manager Investment advisers that serve as portfolio managers in wrap fee programs and manage client assets are typically advisers with established track records. The portfolio manager is typically responsible for the composition of the client s account in accordance with the strategy selected, reasonable restrictions imposed on the account and other information provided to the manager. In determining the composition of client account, portfolio managers typically develop model portfolios that may vary based on the particular investment restrictions imposed by clients (e.g., no alcohol stocks), the timing of cash flows and personal tax planning decisions. Furthermore, some portfolio managers employ a dynamic investment approach in which changes to the model portfolio apply to both new and existing client accounts equally, i.e., all accounts look substantially similar (subject to restrictions, etc.). Other portfolio managers employ a static investment approach in which changes to the model apply to new accounts but there is greater room for variance among existing accounts within certain ranges. It is common for portfolio managers to trade through the sponsor as broker or dealer. However, certain portfolio managers, particularly those managing fixed income and small cap portfolios, may trade away from the sponsor in order to satisfy their best execution responsibilities. Trades are settled in the custodial accounts of the clients on the sponsor s system. The portfolio manager often produces, or assists the sponsor in producing, periodic commentaries regarding its strategy and its views on the markets. C. Multi-Manager Programs and Overlay Managers The past few years have seen a rise in the prominence of multi-manager wrap programs, sometimes called multiple style accounts or multi-disciplinary programs. These programs have facilitated the ability of smaller clients to access institutional quality managers and the benefits thought to inure to professional money management. Such clients, especially retail investors of brokerage firm sponsors might not have sufficient assets to: 1

5 329 Reach investment minimums typically required of institutional accounts; and/or Effectively diversify among multiple asset classes and investment styles. Such clients also may not have the time nor expertise to identify, analyze and/or to periodically monitor the investment process or compliance, legal or other operational and infrastructure issues, among other things, that may impact a portfolio manager. Sponsors of multi-manager wrap programs generally seek to include high-quality asset managers and to assist clients in allocating among various investment styles and asset classes in an effort to enhance investment returns while reducing portfolio risk and volatility. While the sponsor and its representatives often provide consulting and other non-discretionary advisory services, the client typically directly appoints the third-party portfolio managers (which could be unaffiliated or affiliated). There are many variations as to how particular multi-manager wrap programs are operated in terms of the amount of discretion the sponsor, overlay manager (discussed below) and portfolio managers have with respect to the management of the client s portfolio, rebalancing, cash flow management, reporting and other operational aspects. II. VARIATIONS OF WRAP PROGRAMS A. Model Programs and Overlay Management To enhance multi-manager programs and coordinate the management of the various portfolio managers, in recent years program sponsors have incorporated overlay managers into their multi-manager programs or offered overlay management through an independent platform. Overlay management is designed to offer one or more of the following benefits: A more optimized approach to rebalancing which may seek a more coordinated approach to allocating cash distributions, contributions and withdrawals, transitioning securities into or out of the portfolio, transitioning holdings upon portfolio manager replacement and rebalancing portfolio manager and asset-class weights; More efficient cash management; Portfolio optimization by seeking to eliminate wash sales and over-concentration; Proficient tax management across portfolio managers by coordinating and improving tax-lot management (by maintaining tax lot information, selling the best lot if held by more than one portfolio manager, harvesting tax losses around the portfolio managers holdings and matching losses with gains); Enhanced risk management; Monitoring the entire portfolio within specified guidelines of the investment guidelines/restrictions and against the target benchmark; 2