Picking a Strategy for Diversifying Investments

Diversification is one of the few investment concepts that just about everyone stands behind. Buy enough stocks, bonds, mutual funds or whatever, and you can actually reduce risk while maintaining or enhancing your returns.

But diversification means different things to different people. And the question of how much diversification you need is a central issue in the debate between mutual funds and their fast-growing competitors: wrap-fee accounts.

Both products provide diversification, and in larger amounts for lower cost than you would get by purchasing individual securities on your own.

With mutual funds, money pooled from investors is used by the portfolio manager to buy dozens if not hundreds of stocks or bonds. Each shareholder owns a piece of the overall pie.

Wrap accounts, which are designed for people with $100,000 or more to invest, operate differently.

With the help of a broker, you select a money manager, who buys a personal portfolio of stocks or bonds for you. The broker then monitors the account and might recommend a new manager if the performance lags or your circumstances change.

You don’t necessarily get a unique portfolio because the manager will put his favorite stocks or bonds in all of the wrap accounts. But you do get some personalized services unavailable with mutual funds.

For example, if you object to tobacco stocks for moral reasons, you can ask that the manager exclude these. Or if you want to realize some year-end losses for tax reasons, the manager can sell your lagging stocks.

Also, with a wrap account, there’s no danger that your investment will be hurt by heavy redemptions by other shareholders--a potential problem with mutual funds.

In addition, wrap investors often can speak with their managers, although managers don’t have the time or inclination to debate investment details with smaller clients.

All trading and service costs, including the broker and manager’s compensation, are wrapped into a single fee averaging 2.5% to 3%. The single fee removes the threat that the broker will recommend trades for the purpose of driving up commissions--an unethical practice known as churning.

Critics have attacked those 2.5% to 3% wrap fees as excessive, especially compared to the 1% to 1.5% in annual expenses typical of mutual funds (excluding sales charges, if applicable).

Proponents defend wrap costs as worth the price for the added services. Some also argue that comparing the two types of products is difficult because wrap fees include brokerage costs, whereas mutual fund expenses do not.

Mutual fund brokerage commissions might run 0.75% to 1.25%, estimates Daniel R. Bott, a broker/financial consultant in Scottsdale, Ariz., for Smith Barney Shearson and author of an upcoming book on wrap investing.

“Wrap-fee accounts versus most no-load funds are usually close or lower in overall costs,” Bott says.

But Morningstar Mutual Funds, the Chicago-based research publication, pegs brokerage costs closer to 0.2% for the average growth-and-income fund. That would still give mutual funds a edge over wrap accounts of about 1% a year.

For the stingiest index funds, which have virtually no trading costs and expense ratios below 0.5%, the gap would exceed 2% a year.

Are the additional services provided by wrap accounts worth the extra cost? Proponents insist they are, while critics just as vehemently say no.

It is worth noting that performance-based comparisons between the two products are tough to make. While newspapers, magazines, newsletters and research services publish fund performance returns--net of all fees and independently verified--there is no such easy public access to wrap results.

“Wrap accounts operate under a veil of secrecy with no newspaper pricing, no comparisons to competing accounts and no third-party evaluations,” argues Don Phillips, Morningstar’s publisher.

But perhaps the deciding factor is diversification. With $100,000 or less in mutual funds, you can get several different portfolios covering small growth stocks, large value stocks, foreign bonds, European equities, tax-exempt bonds and everything in between.

Too much diversification isn’t recommended, since that would lead to mediocre returns. But at least you can get what you want at little cost.

By contrast, a $100,000 wrap account might hold as few as eight to 12 stocks, managed by a single professional.

“I wouldn’t put all my money with anybody,” says Michael Stolper, a San Diego-based adviser who matches professional managers with clients having $1 million or more. For his customers, Stolper recommends a minimum of four managers, each specializing in one of the following areas: large growth stocks, small growth stocks, value companies and international equities.

Wrap clients able to afford only one manager are at a diversification disadvantage, he says, especially given the higher costs involved.

Bott agrees that wrap accounts work best when the money is split between at least two managers, which requires investors to have $200,000 or more.

“A minimum of two managers will improve long-term performance and reduce volatility,” he says.

In short, wrap accounts probably aren’t as bad as their critics claim, nor as good as their proponents argue. But it’s a stretch to say they work as well as mutual funds for people with only $100,000 or so to invest.

Fund Notebook

The fact that so little hoopla accompanied the stock market’s recent climb to record territory may be a bullish sign.

Prior to normal peaks, the press plays the market’s performance as a major news story, generating public excitement, says Arthur Bonnel, who runs the no-load MIM Stock Appreciation Fund, based in Independence, Ohio.

But this time that hasn’t happened, and the mood on Wall Street is one of caution.

“It’s almost exciting and fun to watch all the negative news come out,” says Bonnel, whose fund has an above-average rating from Morningstar Inc.

Barring a change in investor psychology, he sees the Dow Jones industrial average hitting 4,000 by year-end.

The Rap on Wrap

Wrap-fee accounts have become a formidable challenger to mutual funds for medium-sized investors. The accounts now total about $50 billion under management, up from $10 billion five years ago, estimates Daniel R. Bott, a broker and financial consultant for Smith Barney Shearson. The following characteristics--most of which don’t apply to mutual funds--are typical of wrap investing:

* A customized portfolio of stocks or bonds, insulated from the redemption activity of other investors.

* A single, all-inclusive annual fee of 2.5% to 3%.

* Personalized, tax-related selling available.

* Brokerage help in selecting and monitoring a money manager.

* Ability to talk with the manager on occasion.

* Ability to exclude morally offensive securities from the portfolio.