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Model Portfolios As A Viable Option


Some financial advisors are into portfolio management and prefer creating investment portfolios for their clients. Others aren’t. For advisors who’d rather outsource some or all of their investment management in order to focus on comprehensive financial planning, they can turn to model portfolios. And increasingly, they do.

To use a trendy word, model portfolios are “curated” strategies of prebuilt portfolios where the design, construction and ongoing due diligence are handled by third-party providers. They first hit the scene in the early 1990s when Brinker, Lockwood and SEI rolled out mutual fund-based models, according to Scott Smith, director of advice at Cerulli Associates. Later, third-party strategists came out with models based on exchange-traded funds. Some asset managers believe the next stage in the evolution of model portfolios will incorporate sophisticated strategies—such as managed correlation—designed to provide a smoother ride than traditional modern portfolio theory.

A survey of advisors from FlexShares, the ETF unit of Northern Trust Asset Management, found that 43% of respondents used third-party managers for all or part of their investment management needs in 2018. That was up from 40% four years earlier. On average, advisors who employ external investment managers delegated 57% of their assets under management in 2018. In addition, 97% expressed satisfaction with those external solutions.

AssetMark found similar satisfaction levels in its “2019 Impact of Outsourcing Study.” Among the report’s other findings is that 68% of advisors said the use of model portfolios helped deliver stronger client relationships, 65% said it increased client retention, and 48% said it led to more client referrals.

“While outsourcing may not be right for every advisor, it was found to help meet a wide range of advisor goals,” the report said.

Granted, both Northern Trust and AssetMark are in the model portfolio business, so they have a vested interest in conducting surveys that put these products in a positive light. Still, various realities make outsourced model portfolios a good option for some, if not many, advisors.

For starters, many registered investment advisors don’t have the time, staff or other resources to build portfolios. And then there’s the fiduciary angle.

“We see fiduciary concerns as a big reason why advisors are outsourcing some of their investment management to these models,” says Nadia Papagiannis, practice lead for multi-asset class solutions at Northern Trust. “There’s the idea you have to provide the basis for all of your portfolio recommendations. And if you don’t have a staff that’s working full time on asset allocation and monitoring what’s going on in the economy, do you actually have a basis for what you’re recommending in your clients’ portfolios?”

She adds that the largest end users of model portfolios—and those who benefit the most from them—are financial advisors at insurance broker-dealers, bank broker-dealers and the smaller RIAs who don’t have a lot of home office investment resources at their disposal.

Northern Trust takes a tactical, factor-based approach with a roster of five diversified strategist portfolios that range from conservative (income-oriented) to aggressive (stressing maximum asset growth). All of its portfolios contain four asset classes (equities, fixed income, real assets and cash/ultra-short bonds) and are based on the same mix of FlexShares ETFs and Northern Trust’s mutual funds. Most of the ETFs tilt toward factors, which are defined as persistent drivers of return. The FlexShares ETFs in these portfolios focus on four factors: value, size, quality an dividend yield.

Papagiannis posits that the benefit of a factor focus is that it gets you exposure to these forces of excess return without the risks posed by passive indexes that can introduce sector or regional biases over time.

Northern Trust’s investment policy committee takes both a top-down and bottom-up approach in developing its annual forward-looking risk/return assumptions for the asset classes in its model portfolios. This determines which assets classes it should overweight or underweight. Afterward, the committee meets monthly to read the tea leaves and make tactical adjustments in the portfolios to address the current market, economic and political environments or any other exogenous factors.

“Every month we provide an update on our current tactical view of the market and what changes are being made in the models as a result,” Papagiannis says.

She notes the key to combining various factors into the model is making sure they don’t neutralize each other. “Our FlexShares ETFs with factors have been designed specifically to be combined with other FlexShares ETFs so that they don’t cancel out each other,” she says.

The underlying investment fees in Northern Trust’s five model portfolios range from 40 to 46 basis points. Plus, it charges up to 25 basis points for trading and rebalancing the portfolios. These fees, plus the financial advisor’s fee, are wrapped up in the final cost to the client.

Avoiding Correlation

Managing correlations is the new black for portfolio management, says Arnim Holzer, macro and correlation defense strategist at EAB Investment Group. His firm specializes in risk mitigation strategies and works with hedge funds, family offices, investment companies and RIAs to implement customized investment techniques and models designed to participate in up markets while protecting capital in down markets.

His basic thesis is that volatility can be good and correlations can be deadly for portfolios, so portfolios can be structured to capitalize on the former while mitigating the latter. “The only way to do that is to get asymmetry between the ups and downs,” Holzer says. “To do that, you use options, you use derivatives.”

He notes those strategies have been used by hedge funds and large institutional investors for a long time, and the democratization of the intellectual property for derivative strategies has enabled RIAs with reasonable-sized accounts to access them through liquid alternatives funds.

“Volatility going up doesn’t necessarily damage portfolio returns,” Holzer says. “Where it damages portfolios is when correlations spike and it leads to changes in the innate relationship between asset classes and between different companies. Your positioning can hurt you because where you’re short or long no longer retain the bias of the correlation you expected of them. That means you can have correlations spike, and that’s the most dangerous environment.”

Holzer offers that his firm’s managed correlation approach makes asset allocation models more robust because it makes them “notably different allocations than traditional asset allocation models.”

“Taking a managed correlation approach creates a whole new set of opportunities for tightening expected return distributions,” Holzer says, adding he thinks that’s where the industry is going. The industry “has been focused on volatility, but volatility tells only part of the story.”

Mass Affluent

David McNatt, senior vice president in charge of product strategy and management at AssetMark, notes that one of the trends he’s seeing in model portfolios is a greater demand for tax-aware investing after a 10-year bull market that has ballooned asset values and people’s net worth. “Advisors are targeting a larger base of high-net-worth clients, and those clients are much more tax aware and focused on municipal portfolios,” he says. “That’s an area we’re seeing a lot of growth on the platform.”

AssetMark provides advisors with a range of prebuilt investment solutions based on a variety of different risk profiles for clients. It can also customize solutions that combine investment management and a variety of specialized services that advisors deal with such as a concentrated stock position or complicated tax situations. Through this year’s first half, AssetMark’s platform had nearly 7,900 advisors and approximately 155,300 investor households. It had total platform assets of $56.1 billion.

McNatt says another trend he’s seeing is a demand for model portfolios geared toward mass-affluent investors. “These people have personalized needs for their investments,” he notes. “Perhaps they’re more tax-aware, or need to deal with the transitions of legacy assets to avoid tax consequences.”

AssetMark last month launched a new offering called Savos Personal Portfolios, which the company says puts high-net-worth-like features and services into a program to serve emerging or mass-affluent clients “at an accessible investment minimum.”

The program features strategies managed by Savos Investments, and they incorporate stocks, fixed income and a tactical strategy aimed at providing additional equity exposure in up markets and reduced equity exposure in down markets.

Not every advisor needs or wants model portfolios. Some advisors use them as a cost-efficient way to serve lower-net-worth clients and prefer to personally handle the portfolios of their larger clients. “They want to provide a higher-touch service to those types of clients, and aren’t willing to completely outsource that,” says Papagiannis from Northern Trust.

Scott Smith from Cerulli sees the use of model portfolios as a growing long-term trend. “New people coming into the advisor industry will more likely focus on financial planning than portfolio management,” he says. “So I think we’ll see this grow through attrition, as younger advisors are more likely to see financial planning as their alpha opportunity.”

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