With wrap accounts, the broker manages an investor's portfolio for a flat quarterly or annual fee. This fee covers all of the broker's administrative, commission and management expenses. Wrap accounts are designed to ensure that the broker doesn't trade excessively for the sake of getting commissions. Ideally, this would allow brokers to serve the investors' interests without worrying about their profit. However, the very structure of the wrap account leaves it open to abuse, allowing brokers to overcharge for their services without working up to capacity--in other words, leaving investors with large bills and few results.
Advantages of a Wrap Account
As mentioned above, the biggest advantage of wrap accounts is that they are especially designed to prevent churning--excessive trading that occurs solely for the sake of generating more commissions for the broker. This hurts the investor in two ways. First, it makes it nearly impossible for the investor to benefit from long-term investments. Second, since churning involves trading for the sake of trading, the broker won't try to trade in the way that would benefit the investor. At best, the investor would be left with as much money as he or she started out with. At worst, the investor would actually lose money. Either way, the only person who earns any profit is the broker.
The wrap account prevents churning by capping the total broker fees at 1 to 3 percent of the investment account's balance. The exact percentage varies depending on the broker and/or the brokerage firm. Once the percentage is set, it will remain the same for as long as the investor uses the broker's services.
Another benefit of wrap accounts is a relatively low initial investment. Most initial investment can be anywhere between $2,000 and $25,000. This makes the wrap accounts accessible to middle- and working-class investors. Yet in spite of the relatively low initial investment, the quality of service tends to be high. The investors with wrap funds benefit from services of professional, high-paid brokers who are well equipped to handle the investors' needs and goals.
Disadvantages of the Wrap Account
As with many investment devices, the wrap account's biggest strength is also its greatest weakness. Since the fee the investor pays is flat, it doesn't really matter how much work the broker does. That means that, even if the broker comes to work every day and does nothing but play video games, she will still get the same flat fee as if she were working overtime.
Even if the broker does her job properly, she will benefit from a fee that's structured to benefit the brokers first and foremost. As mentioned before, the fee represents a fixed percentage of the account. As a result, the ratio between profits and the fee remains the same. The more the account grows, the more the investor will have to pay the broker. This, in turn, means that investors' profits will be artificially restricted regardless of how much the accounts earn. The only person who benefits in this arrangement is the broker, who reaps the increasing financial rewards every step of the way.
Another disadvantage of wrap accounts is that the investment fees are actually higher than the average commissions on other types of investment accounts. In fact, the 3 percent of the account represents the maximum legal threshold the investor can earn. This means that, generally speaking, the investors with wrap accounts get less value for their money than the investors that don't have them.