The Effect of Zero Dollar Commissions on Wrap Fee Programs
Author: Kaley Mitts & Chris Payne
October 3, 2019
On October 1st, Charles Schwab and TD Ameritrade announced they will reduce their commissions on U.S. stocks, exchange-traded funds (“ETFs”), and option trades to zero. On October 2nd, their rival E*Trade Financial joined in the race to zero commissions, leaving only Fidelity standing resolute (for now). In the last five years, we have seen a drastic increase in the number of commission-free ETFs, as well as dramatic reductions in commissions and trading costs. As the cost to trade has gotten cheaper and cheaper, and has now been eliminated, it is time to ask --- do wrap fee programs need to be re-valuated?
What is a Wrap Fee Program?
A wrap fee program is defined within the Investment Advisers Act of 1940 as a “program under which any client is charged a specific fee or fees not based directly on transactions in a client’s account for investment advisory services (which may include portfolio management or advice concerning the selection of other advisers) and execution of client transactions.”
Wrap fee programs were designed to provide a consolidated fee structure to clients confused by the myriad of fees that often hit their account statements. The wrap fee bundled the many types of fees clients paid into a single fee, typically based on a percentage of assets under management. In general, clients enrolled in wrap fee programs pay higher fees than clients participating in non-wrap programs. Whereas non-wrap advisory programs seem to hover in the 0.75-1.50% range, wrap fee programs often range anywhere from 1.00-2.50% range.
RIA's Offering Wrap Fee Programs Should Re-Evaluate Now
Due to the higher advisory fees, the Securities and Exchange Commission (“SEC”) has been giving wrap fee accounts increased scrutiny for the last 5-10 years. The focus of the SEC has primarily been on suitability and disclosure issues. Some advisers put their clients in wrap fee programs, only for the accounts to remain concentrated in cash or have little-to-zero trading activity. The SEC generally takes the position that these accounts were unsuitable for the wrap fee program, and the issue is compounded for those investment advisers who have traditional managed accounts or are dual registrants.
Even for accounts with significant trading activity, many wrap fee programs were originally developed in a high transaction fee environment. Many advisers likely remember a time where it wasn’t unusual for a transaction fee to cost $25-$50 (or more) for each side of the trade, meaning the client would pay $40-$100 roundtrip for each security. As trading costs have decreased, the attractiveness of wrap fee programs has gradually decreased as well, as higher trade volumes are necessary to justify the higher bundled fee.
With the new zero-commission trading structure amongst the major brokerage firms, it is time for registered investment advisors to re-evaluate their wrap fee program. The Investment Advisers Act requires an investment adviser to act as a fiduciary for their clients, and the race to zero commissions means it is even more likely the SEC (and clients) will raise the question: What exactly is the benefit of wrap fee account if transaction fees are zero? If the Adviser struggles to justify the higher advisory fee based on a combination of quantitative and qualitative factors, then it might be time to make a change.
What Can We Expect Next?
Wrap fee programs have long been a priority of the SEC’s, but in light of the recent fee changes, we can expect a heightened focus on the programs. Firms should be conscious of the current regulatory environment and the responsibilities that come along with offering bundled fee structures. Procedures should be set in place to assess whether advisers are fulfilling fiduciary obligations to clients and making sure their fees are within the client’s best interest. Investment advisers with both a wrap fee program and non-wrap program or an affiliated broker-dealer should be particularly aware that they have established their own barometer from which they’ll be judged.
Key Bridge Compliance is already working with a number of firms to assist them in assessing the suitability of their wrap fee program. If you have similar needs, we can help you make appropriate decisions on how to address your wrap fee program, and how to prepare for your next SEC exam.