How financial planners should use model portfolios

Many financial planners now use model portfolios to assist in the complex task of managing their clients’ wealth. But is a model portfolio the best option, and what are the key issues advisers should think about when considering this approach? Dominic McCormick reports.

In most cases, model portfolios are a major improvement on the increasingly tainted approach involving planners building clients’ portfolios on an individual basis by selecting from long-approved product lists (APLs) that usually include every product category (and in some cases, it seems, almost every product).

That ‘model’ has clearly failed many clients and dealer groups.

Apart from the greater risk of investment blow-ups (and lawsuits), it results in little consistency in portfolios between advisers within a dealer group, little overall risk control and resulting difficulties in presenting a coherent adviser brand to clients.

Therefore, in theory, model portfolios (done well) allow the creation of portfolios with more consistency, control and client certainty. In practice, however, there are significant limitations and issues.

Model portfolios are often not followed properly

Many model portfolios are simply used as a reference portfolio rather than a prescription for all clients. There is often still considerable freedom for advisers to pick and choose from that model portfolio and possibly other funds.

My experience is that behavioural biases push advisers to pick more of those investments in the model that have performed well recently while leaving out, or down-weighting, those that have recently performed poorly.

Typically, this leads to underperformance of client portfolios versus the models as performance of the ‘out-of-favour’ investment managers (and assets) rebounds while previous ‘hot’ managers or areas actually underperform.

Implementation issues (leading to performance drag)

Even when followed closely, the practical implementation of model portfolios presents problems, as it is often difficult and delayed.

For example, depending on the structure used and the need for client consent, it can take weeks to implement asset allocation or manager changes. In a world where markets are moving as much as 10-15 per cent in a month, the drag on performance from delayed decisions can be significant.

Of course, many platforms have developed faster and more discretionary arrangements to make asset allocation and manager changes quicker, but even with these systems there are problems.

Too often, such model portfolio changes are driven on a planning timetable (such as the timing of quarterly/half-yearly reviews) rather than a true investment timetable (ie, when it is judged the best time to implement given market movements and opportunities).

In practice, successful asset allocation can often involve a number of small (but cumulatively significant) moves over an extended period, buying or selling into weakness or strength as dictated by the market.

This is difficult to implement for planners using model portfolios, and there is often a discord between the investment theory and the implementation.

Model portfolios encompassing listed investments also present significant problems. There is the significant administration burden involved in dealing with corporate actions (eg, capital raisings, takeovers) and the need to deal directly with clients on issues, such as funds for rights issues.

There is also the problem of the queuing of orders when a new buy or sell recommendation is made. Planners and clients can end up jumping in front of each other, with the result that the price moves unfavourably for the clients before the trades are executed.

Restricted investment universe

While there is clearly no need to use all available investments, having as wide a universe as possible is the best starting point. Instead, most research houses and planners developing model portfolios have a much more restricted opportunity set.

This is because they:

• are usually restricted to funds with a local PDS excluding some investments available to institutional investors;
• can be restricted to using funds available on the wrap/administration platform used by their dealer group;
• are often restricted to only those funds rated/reviewed by research houses; and
• usually exclude less liquid and many alternative investments.

Model portfolios deal poorly with less liquid areas. Even investments with weekly or monthly liquidity don’t fit in well with many platform-rebalancing arrangements.

Recent liquidity problems with a range of investments areas are likely to further restrict the inclusion of less liquid and alternative investments generally featured in model portfolios.

However, some exposure to less liquid areas in clients’ portfolios can be very appropriate, where a sufficient illiquidity premium is received and is for diversification purposes.

Implementing strategies around portfolio construction

Not only can the investment universe be seriously constrained, but the strategies that can be overlayed on that investment universe to increase returns and/or manage risk are much more restricted.

For example, it is very difficult, if not impossible, to implement explicit currency hedging in model portfolios.

In addition, introducing any form of option protection to limit downside risk can also be extremely difficult, if not impossible.

Yet the flexibility to implement such strategies can be the key between success and failure in portfolio construction.

Conflicts of interest

Some firms depend on manager rebates as part of their revenue and, as a result, some managers may be included or excluded from model portfolios for reasons that have little to do with their investment merit.

This also tends to result in model portfolios favouring large managers over small, given their greater ability to pay such rebates despite a strong case that many of the best-performing managers can be found amongst the smaller boutique managers.

The current regulatory overhaul may well eventually eliminate this practice.

Then there are the real and perceived conflicts that impact brokers and research houses that provide model portfolios.

Some stockbrokers might be perceived to skew portfolios towards ‘house stocks’, where they earn corporate revenue, while some may be given an incentive to change the portfolio frequently to generate transaction revenue.

Research houses, which charge fund managers for ratings, are only able to produce model portfolios from this restricted universe of managers, since those are the only ones they have researched, while other research houses managing their own multi-strategy portfolio businesses might be perceived to have a conflict of interest between the investment decisions, and the timing thereof, to be implemented within their own portfolios and communication to clients on their model portfolios.

Excessive brand-name bias

The pressure to use large brand-name managers and to bias model portfolios towards domestic assets, even if this has limited investment validity, may arise from the need to give customers the brands that they know.

This is not a great way in which to build robust portfolios for clients who have put their faith in planners to manage appropriately on their behalf.

Lack of performance accountability

While it should be relatively easy to monitor the performance of model portfolios, it seems that this is something that is rarely done in practice.

As noted above, there are a multitude of implementation issues that tend to result in planners’ clients having significantly different (usually worse) performance than the model portfolio.

As greater scrutiny of the planning industry is brought to bear, planners will be forced to provide more information (and be fully accountable) for their performance in the same way fund managers and multi-managers currently are. I suspect the performance of many model portfolios for actual clients will be shown wanting.

Lack of oversight

Performance is obviously an important element especially over the long-term, but dealer groups need to ensure portfolios are being overseen at an individual client level also.

Dealer groups usually have a good idea of their overall exposure to different investments but this does not prevent the risk of badly structured portfolios at a client level.

Even when model portfolios are used as a guideline, the practice of ‘cherry picking’ from that model as described above, failure to rebalance in a timely fashion, and not properly incorporating a client’s other investments can result in significant variations to the performance of the model portfolio.

Alternatives to model portfolios

So what is the alternative to model portfolios?

Essentially, it is an implemented, multi-asset class, multi-manager approach, where dedicated funds or portfolios are run for clients on a pooled basis, either by the establishment of such capabilities internally or through the use of an external multi-manager group.

Multi-manager, multi-asset class portfolios solve many of the problems discussed above.

Investment decisions can be made and implemented quickly, portfolios are built from a true investment perspective with few conflicts, they provide access to a broader investment universe including some less liquid investments, client investment results are more consistent and risks reduced, and there is greater clarity and accountability for performance.

Of course, multi-managers are not immune from some problems and issues. They may be less transparent than a model portfolio approach.

Depending on how they are structured, they may be less tax effective. They limit the flexibility to structure a portfolio to deal with some specific client issues (eg, income, tax) but, arguably, these issues are outweighed by the advantages.

There can also be significant business advantages that come from such arrangements.

Depending on how it is structured, the fee arrangements can be more clearly defined and free of the conflicts that come with rebate arrangements.

The dealer group and planners can free up time spent on investment research and administration issues, and focus instead on financial planning strategy issues for clients and seeking new business.

If outsourced, this approach may involve placing significant funds with one multi-manager group.

However, in reality, clients are typically much more diversified across assets, managers and strategies than they would be with a standard model portfolio.

Further, the planning group retains the power to change multi-manager groups if necessary. In any case, the regulatory or ‘blow-up’ risk with diversified multi-asset, multi-manager funds is significantly less than that with individual funds.

The regulatory changes coming over the next one to two years are likely to see an increased focus on delivering quality investment solutions and an increased cost of quality unbiased investment research at a time of declining financial planning revenue.

If the ‘pay-for-ratings’ model comes under pressure, financial planning groups will be forced to make the decision whether to bear increased costs directly (via building up in-house research teams or paying more for quality research) or outsourcing a large component of this via an implemented multi-manager approach.

This is a cost that is harder to pass on to clients.

Forward-looking groups are likely to choose the latter, not just from a cost perspective but also because of the administrative and investment efficiencies it delivers.

Some might find multi-manager solutions too conservative for some of their more aggressive clients. For such aggressive clients, they can still form a core and more aggressive satellite investments can be added.

For the same reason that most investment managers would not make good financial planners because of lack of skills and training, the same can be said for planners whose skills lie in dealing with complex structural and planning issues.

If advisers think they can do both, they need to make investments in compliance and portfolio management systems to ensure that the clients are getting the optimal result rather than an average one.

Planners, therefore, have to decide whether they are in the investment business or the financial planning business (or both).

If in the former, many will need to be prepared to beef up their own investment resources and focus significantly, as simply utilising research houses and brokers is not enough given the real and perceived conflicts and issues involved.

If they are in the financial planning business, then they need to consider partnering with a reputable and focused multi-manager to deliver well-diversified, credible solutions to clients, possibly tailored to their needs.

Dominic McCormick is chief investment officer at Select Asset Management.