Wrap Account Services in Korea - Current Status and Prospects

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1 Funds and Pensions Wrap Account Services in Korea - Current Status and Prospects Hong Sun Song, Research Fellow* I. Introduction After the 2008 financial crisis, tailored wrap fee services rapidly gained popularity among Korean retail investors. From the demand side, the growth momentum came directly from mutual funds stigma effect that underperformed the benchmark KOSPI during the crisis. Retail investors focus on the merits of wrap accounts such as customization and high returns. Wrap accounts have so far met expectations and outperformed mutual funds since The supply-side growth impetus is closely related to advances in financial technology, which have reduced the unit cost of wrap account services low enough to make the services attractive even to small investors. This article describes the current status and characteristics of wrap account services, in comparison to the US market, and then discusses some challenges for improvement. * All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as the Korea Capital Market Institute s official position. Tel: , dna0214@kcmi.re.kr 35

2 Capital Market PERSPECTIVE II. Current status of the wrap services market: a comparison with the US 1. Regulatory platform Debates about wrap accounts center on the customized nature of wrap-fee clients. By definition, a wrap service provides each investor with personalized service according to the investor s financial status and investment purpose. Customization is a key attribute distinguishing wrap services from other standardized investment products such as stocks, bonds, and mutual funds. However, in reality, the boundary between tailored services and standardized products is getting blurry as financial IT develops. Actually, financial IT helps portfolio managers to simultaneously utilize one model portfolios for more than two wrap clients. In this case, however, clients with similar investment objectives, each of whom deserves customized service, may hold similar securities in their accounts. Hence, the use of a model portfolio in wrap services has led to controversy over the difference between mutual funds and wrap services. The criticism is that the adoption of a model portfolio by wrap services blurs the difference between the two products and erodes the advantage of customization. They argue that without customization, clients of an investment advisory program will not receive individualized advice. Although an adviser uses a model portfolio to manage client accounts, he still has the obligation to offer customized services. At the moment, after extensive debates, some compromise has been made to alleviate the conflict between mutual funds and wrap accounts. In exchange for the use of model portfolios, wrap service providers will abide more strongly by the suitability principle. This approach was first introduced when the US introduced a safe harbor clause for the Investment Company Act of The new clause stipulated that the investment adviser does not have to consider the individual needs of the company s shareholders when making investment decisions, and thus has no obligation to ensure that each security purchased for the company s portfolio is appropriate for each shareholder Vol. 3, No. 2

3 Wrap Account Services in Korea - Current Status and Prospects Despite the regulatory compromise, the US SEC requires wrap account sponsors to evaluate the suitability of each transaction for each client. The UK also adopted this solution and permitted an exception to the Financial Service and Market Acts of Korea s government has also considered this policy approach to distinguish wrap services from mutual funds. It is worth noting here that Korea takes a different stance from the other two nations: Korea explicitly stipulates specific guidance regarding suitability principles in the law, and any market player who does not comply will be put on the financial regulator s watch list. 2. Market status A. Market size Wealth management for the rich has been available for a long time in Korea. However, recent wrap accounts services are the first market driver, creating a higher value-added service and gaining popularity. A comparison of Korea s wrap account market to the US market provides a better understanding of the size, depth, and characteristics of Korea s wealth management market. Due to the huge differences, it is not meaningful to compare the absolute size of the Korean and the US markets. It s better to look into the two markets relative size, specifically, the relative size within the indirect investment market. As of end-2010, the relative size of wrap accounts in the total mutual funds market in Korea was 11%, which is lower than the 15% for the US. However, Korea s growth is truly remarkable because wrap accounts have existed for over 20 years in the US, while it was only recently, two to three years ago, when wrap accounts were first introduced in Korea. More surprising is the equity-type wrap accounts. As shown in Table 1 and Table 2, the proportion of equity-type discretionary wrap accounts in Korea reached 7.8% as of February 2011, while the figure in the US was around 3.2% as of

4 Capital Market PERSPECTIVE Table 1. Equity-type wrap accounts and mutual funds in Korea (Unit: KRW billion, %) Mutual funds (A) Wrap accounts (B) B/A March , May ,349 1, December ,934 5, February ,127 7, Source: Financial Supervisory Service (FSS), Korea Financial Investment Association (KOFIA) Table 2. Equity-type wrap accounts and mutual funds in the US (Unit: KRW billion, %) Mutual funds (A) Wrap accounts (B) B/A , , , , Source: Money Management Institute (MMI) B. Market depth As for market depth, such as service diversity and investment period, Korea s wrap account market lags behind the US market. If the market is equipped with diversified wrap account products, then this means that customers can enjoy customized wealth management services that suit their financial condition, investment purpose, and risk appetite. In terms of diversity, Korea s market leans too much toward equity-type wrap accounts unlike the US market where bond-type products represent the largest portion with 34% of the total wrap accounts, followed by domestic equity products (32%), overseas equity products (16%), and other products such as hybrid and alternative investment types as indicated in Table Vol. 3, No. 2

5 Wrap Account Services in Korea - Current Status and Prospects Table 3. Wrap accounts by type in the US (Unit: %) Q, 2010 Domestic equity-type Overseas equity-type Bond type Hybrid type Alternatives type Total Source: MMI Another important measure is the investment period. Wealth provides returns from asset allocation rather than from market timing. According to subscription forms for wrap accounts, financial firms in the US never recommend to customers whose investment period is less than two or three years to invest in equity-type wrap accounts. Although this is not mandatory, financial firms themselves abide by the principles of good faith and manage their risk and reputation. 1) Korean financial institutions also advise investors to hold their wrap account investments for more than one year, but some wrap service providers induce their customers to engage in short-term (less than one year) investments. Simply put, excessive competition in the market undermines the benefits of wrap accounts. Investment periods are the most important factor in devising a strategy for advancing the wealth management industry in order to rebuild the old-age income security system. III. Challenges for advanced wrap account services 1. Suitability principle in financial advisory services Wrap accounts should be subject to more stringent principles of suitability compared to other financial vehicles. Unlike other standardized financial vehicles, 1) Of course, the US has the capital gains tax, which is a strong incentive for long-term investments. 39

6 Capital Market PERSPECTIVE wrap accounts can be modified and combined with other financial products according to customers needs. By nature, wrap accounts are customized services and this affects the distribution process, from financial advisory to portfolio management to reporting. These customized properties should be considered when designing the principle of suitability for wrap accounts. For these reasons, a wrap account, a form of wealth management, goes beyond a simple service that invests in financial assets for profit. It refers to a comprehensive set of services that consider a customer s wealth management purpose and appetite, decides how to increase the value of a certain asset, and then manage the asset. It also should be a long-term investment service that enables customers to benefit from long-term asset allocation. Figure 1 shows that optimal asset allocation varies according to the investment purpose and risk appetite of each client group. Investors with larger assets tend to be more risk-taking. Figure 1. Risk tolerance and asset allocation by clients group Note: This survey was conducted by MMI in Source: MMI 2. Service innovation Current wrap accounts should be developed into a more universal wealth management platform that can capitalize on more diversified financial products. Two Vol. 3, No. 2

7 Wrap Account Services in Korea - Current Status and Prospects suggestions can be considered. First, Korea should allow more diversified financial products to be included in wrap account portfolios. The US has introduced diverse wrap accounts including ordinary mutual fund wraps, mutual fund wraps with a hedge fund strategy, and ETF wraps as shown in Figure 2. In addition, wrap accounts, by nature, allow a higher level of customization and more investor rights compared to funds. Therefore, wrap accounts can be more useful for products with greater investor protection requirements. For example, a hedge fund wrap account provides wider investor protection to individual investors than a fund of hedge funds as shown in Table 4. Figure 2. Innovative wrap accounts in the US Note: The figures in the graph indicate the percentage of respondents who responded yes to the question of whether each of alternative investment policies described in the graph is being adopted by their wrap account program. Source: MMI Another suggestion is service innovation that facilitates long-term investments. More specifically, wrap accounts and retirement plans could be combined. In the US, 25% of retirement plans are held in wrap accounts. Managing long-term investments like retirement plans requires expertise and discretion on investments, and wrap accounts are the most suitable financial vehicle in this respect. Furthermore, investors should be allowed to make additional investments in their individual retirement accounts (IRA) in order to make IRAs function as private pensions. 41

8 Capital Market PERSPECTIVE If retirement plans and wrap accounts are integrated, then this will have many positive effects: revitalize fund wraps; help investors benefit from long-term investments, portfolio diversification, and customized services; and create an environment where wrap accounts and funds can grow together. All of these merits have been evidenced by the US market as seen in Figure 3 and Figure 4. The fund wrap market grew and became as big as the individual stock-type wrap market, and since 2000, the two markets have continued to grow based on a complementary relationship rather than replacing or competing with each other. Figure 3. A competitive relationship between wrap services and mutual funds in Korea Figure 4. A complementary relationship between wrap services and mutual funds in the US Vol. 3, No. 2

9 Wrap Account Services in Korea - Current Status and Prospects 3. Developing distribution channels Wealth management consists of two equally important components: investment solicitation and investment management. Solicitation means recommending a portfolio that suits an investor s investment purpose, financial condition, and risk appetite. The long-term investment returns depend largely on how well a financial adviser complies with the fiduciary duty during the solicitation process. This regulatory infrastructure needs to be improved so that the wealth management industry can win public confidence and grow in size. This will help to solidify the three-tier, old-age income security system. In theory, a financial adviser should be a disinterested party in order to recommend the best product to the customer. In this regard, distribution channels are important. The history of the fund sales channel in developed nations shows that the old distribution channels, which were financial product manufacturer s branches, evolved into an independent fund supermarket. Korea s distribution channels still belong to financial product providers. To end the controversy over investor protection and to advance wealth management services, Korea needs independent fund sales channels similar to a fund supermarket. 43

10 Capital Market PERSPECTIVE References Bines, H., Thel, S., 2004, Investment management law and regulation, 2nd ed., Aspen publishers. Chambers, L., Ziesenhein, K., Travisani, P., Seperate account management an investment management strategy designed for net worth individuals, Wiley. Gresham, S.D., Oransky, A.S., 2008, The new managed account solutions handbook, Wiley. SEC, Status of investment advisory programs under the investment company act of Song, H.S., 2010, Wealth management services in Korean securities firms, Issue paper, Korea Capital Market Institute(In Korean). Wilkinson, D., 2006, Stop waiting your wealth in mutual funds, Kaplan publishing. Website MMI Vol. 3, No. 2