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Copyright 2003-2004

WRAP FUNDS VERSUS LINKED PRODUCTS (Personal Finance October 2000)

There has been much debate about the pros and cons of wrap fund of late. Before reaching a verdict on this form of investment, it is necessary to look at the evolution of the unit trust industry in South Africa. Back in the 70's the investment vehicle which dominated was the traditional Assurance type endowment policy. These had many inherent problems for the investor including very high initial costs, very little transparency and poor liquidity. On lump sum investments the only commission to the broker was the "upfront" commission and there was therefore very little incentive to provide ongoing monitoring or "management" of the investment. This in turn cultivated the "hit and run" mentality of many of the older school Assurance brokers which gave the assurance industry such a bad image.

It was against this background that the unit trust industry gained so much popularity in the 80's. Unlike endowment policies, here was an investment whose performance could be monitored in the daily press by virtually anybody. Costs were transparent and the investor could exit the investment at any time without penalty.

The swing to unit trusts gathered momentum and by the mid 1990's the number of unit trusts on offer rocketed from a handful to over a hundred. With so many different unit trusts available the merits to switch from one unit trust management company (Manco) to another gained ground but, as this necessitated selling units from the first Manco and repurchasing new units from the new Manco (once again paying all the up-front costs), it became an expensive exercise. Enter: the Linked-Product industry.

The Linked Product provider acted almost as a wholesaler of unit trusts - representing all of the different Manco's - and this allowed the investor to switch between Mancos at very little cost. In return for this benefit the investor would pay an additional annual fee of approximately 1% to the Linked Product provider of which 0.5% went to the financial advisor. Unlike the old endowment salesman, the financial advisor would now have an incentive to provide ongoing advice on the investor's portfolio of unit trusts. Brokers promised to monitor the clients unit trusts and would contact the client when the broker felt it was time to switch..

This all looked fantastic on paper but soon the wheel's started to fall off. By 1997 the bulk of new money flowing into the industry was coming via the Linked Product route. At this point anybody could enter the financial advisor industry without any qualifications (still the case to this day) and suddenly all sorts of individuals from all walks of life had become stock market gurus overnight. Financial advisers now assumed the role of investment managers and were blatantly ill equipped to do so. Many advisers simply chased last quarter's top performers which created tremendous "churn" in the industry. Advisers active in the industry landed up with hundreds of different portfolios to manage which often resulted in smaller client's portfolios being forgotten about in the rush for the next switch. There were no controls or benchmarks against which each portfolio was measured. When asked by a prospective client how an advisor's existing portfolios had done - the advisor could proudly pull out his top performing portfolio and the client never got to see the other 99 losing portfolios. The difficult market conditions accelerated the problems and many advisers reverted to the old tricks of grabbing the up-front commission and simply forgetting about the investment thereafter.

Once again necessity was the mother of invention, and the Wrap Fund industry entered the fray. The Wrap Fund vehicle was essentially an enhancement of the linked-product portfolio of unit trusts in that, under this arrangement, a Financial Services Board (FSB) approved investment manager received a mandate from the investor to switch between units on the investors behalf. Wrap Funds were constructed according to different risk profiles and similar investors were pooled into the appropriate Wrap Fund. In the majority of cases the Wrap Fund was given a clearly pre-defined benchmark index against which it was to be measured. Investment managers applying to the FSB for approval to manage Wrap Funds underwent a stringent application process which covered experience, qualifications, administration back-up and numerous demanding industry references. In return for the Wrap Fund management of their portfolio, investors paid an average of 0.3% per annum over and above the 1% already paid to the linked product provider.

In recent months, poorly performing stock markets around the globe have started putting pressure on all sorts of equity-linked investments. Wrap Funds have not escaped the criticism and allegations such as high costs, no transparency, no regulation and poor performance have been levied against them. Undoubtedly some of the allegations are true, but it is encouraging that the industry is moving towards improving things, for example, by publishing all Wrap fund performance results in the near future. What many people have overlooked is that the Wrap Fund is a vast improvement on the standard linked-product portfolio, as the table below will show:

Annual Costs (approximate) 1% 1.3%
Regulation of Investment Manager Anybody who becomes a financial adviser can "manage" portfolios. The Investment manager must be approved by FSB.
Performance Transparency None. Who knows how many individual portfolios are out there and what they're invested in? Little public transparency at this time. However most portfolios have pre-defined benchmarks and objectives.
Risk profiling of portfolios Varies completely from portfolio to portfolio. Left up to the investor or the financial advisor. Pre-defined risk profile determined by FSB approved investment manager for every portfolio.
Past performance Who knows? The Advisor could disclose only the top performing portfolios. No benchmark to measure against. Little public transparency at this time. However each portfolio is monitored by the Linked Product Provider and benchmarks are present.

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