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Model Behavior: How Advisors are Utilizing Model Portfolios to Optimize Client Outcomes

Suddenly, model portfolios are generating headlines and conversation industry-wide. Why the growing interest and what does it mean for advisors looking to improve how they serve their clients? Understanding how model portfolios can be integrated into the services advisors provide has important implications for distribution strategies and profitability. What’s driving the trend? How is the industry responding? And what does the future hold for advisors using this tool?

What model portfolios are and why advisors use them

Model portfolios are bundles of investments financial advisors or asset managers assemble to pursue specific goals. Usually consisting of managed investment products, such as exchange traded funds (ETFs) and/or mutual funds1, they’re ideal for individuals who want to invest but don’t have time for extensive investment research. Historically, models have worked well in packaged mutual fund advisory programs where discretionary investment management is outsourced to an investment committee or research team at a distributor. The hypothesis was that these programs would let advisors focus primarily on building client relationships and gathering more assets by outsourcing portfolio management. 

Several factors have fed into the recent uptick in interest. As asset management becomes more complex, advisors face an increasing tension between growing their business and staying connected to portfolio outcomes. More and more, advisors prefer relying on model portfolios to manage assets and focus their efforts on relationship building and client retention.

Brokers/dealers promote model portfolio usage because home offices prefer more control over the investment process. Model portfolios are an efficient way to run investment decisions through stringent due diligence processes. 

Finally, model portfolios can be viewed as a new distribution channel of sorts, enabling active funds to compete against passive funds in portfolios. Some wholesalers now focus less on a mass of individual financial advisors and instead target professional buyers at home offices. For some, this may lead to a realignment of wholesaler distribution forces.

 

Understanding risk levels in model portfolios

Building a core portfolio that targets a desired risk level starts with knowing your clients so you can customize recommendations based on their tolerance for the market’s inevitable ups and downs. Risk models for individual investors utilize the same capital markets assumptions and portfolio construction techniques used by sophisticated institutional investors.

Model portfolio risk levels can be classified into three broad categories: low, medium, and high:

  • Low Risk: Typically designed for investors who prioritize capital preservation over high returns, low-risk portfolios usually contain investments with a lower risk of losing value, such as bonds or fixed-income securities. While low-risk portfolios offer lower potential returns, they are generally more stable and offer a higher level of security.
  • Medium Risk: A medium-risk portfolio features a mix of low and higher-risk investments, such as stocks and bonds. It aims to balance the risk of losing money with a higher return potential. It offers a measure of stability and can generate moderate returns long term.
  • High Risk: Investors willing to take on greater risk in exchange for the potential of higher returns may prefer these portfolios which include more volatile investments stocks of companies with high growth potential or emerging market equities. Along with the potential for high returns – and a higher risk of losing money.

A portfolio’s risk level also depends on other factors, including asset allocation2 investment strategy, market conditions and each individual investor’s objectives. But carefully considering these variables is just the beginning of evaluating their effectiveness.

 

Which investment style makes sense for your client?

Advisors are recognizing that a variety of approaches can be useful in portfolio building. What styles will work best for your clients? What factors should influence your decision? Let’s start by considering the three basic investment styles:

Active investing3 aims to outperform the market by actively selecting individual stocks, bonds, or other securities, using a variety of analyses to make decisions, while factoring in other variables such as economic trends, company performance, and market conditions. The potential to outperform the market draws many investors to active investing and the portfolio may deliver a similar – or even better –  return than the market with lower risk. But active strategies may also underperform. Studies show that some actively managed funds trail their benchmark over time. And finding the right strategy can be time consuming and complicated.

Passive investing tracks to the market or a specific index, such as the S&P 500 or Dow Jones Industrial Average4. Typically, it utilizes a buy-and-hold strategy and emphasizes investing in a diversified batch of securities that mirrors the performance of the underlying index. The buy and hold approach means transaction costs are minimized, and passive investments tend to track well-known market indices, so fees are usually lower.  But since a passive investment is designed to replicate a market index, outperforming that index is unlikely. And concentrating in just a handful of industries may mean more risk than using a more diversified2 approach. 

Smart beta is a relatively new hybrid style, with elements of active and passive investing, utilizing a rules-based approach to pick securities based on factors such as value, growth, volatility, or momentum. Instead of relying on individual stock-picking, this style makes active decisions based on specific factors. It highlights the benefits of active and passive strategies, while mitigating drawbacks. But it tends to cost more than passive strategies, and different factors perform differently than the index in certain market environments. Too much exposure to an investment style out of favor with the market may mean trailing it, at least temporarily.

Client objectives and market conditions should significantly factor into your decision. Also, using all of these strategies could result in earning better overall risk-adjusted returns.

 

Assessing client objectives and risk tolerance

Adhering to a client’s objectives and risk tolerance is key in determining what style model portfolio investing will suit them best. A thorough discovery process is the first step, focused on gathering information about a client’s financial situation, investment experience, and goals. 

A risk tolerance questionnaire5 can tell you more about your client’s willingness to take risks and investing experience. What are their objectives? Knowing if they are prioritizing capital preservation, income generation, or growth can help you create a portfolio that is tailored to those needs. Time horizon is another critical factor. The longer a client’s time horizon, the more tolerance for risk because they have time to recover from market downturns.

 

How model portfolios benefit financial advisors

Time pressures faced by financial advisors show no sign of subsiding and very likely will only increase in the future. By delegating a portion of investment responsibilities, advisors free themselves up to grow their businesses, cultivate client relationships, and enhance the services they provide.

When choosing a model portfolio provider your requirements and specific goals, the level of customization and flexibility offered, types of investments and strategies, costs and fees, as well as technology and processes should all be considered. And requesting references and testimonials is always a good way to get a better idea of overall performance.

 

An efficient way to help your clients and your business

Advisors who utilize model portfolios cite a range of advantages: greater access to investment solutions, better client relationships, and improvements in their businesses as well as better work-life balance and professional growth. From enabling them to spend more time with their clients and increase client acquisition, to retention and building their own skill set.

Model portfolios save time and effort, while providing consistency for large numbers of clients with varying investment needs. Moving forward, these versatile tools will continue to prove invaluable in meeting the changing needs of advisors and their clients.

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1Mutual Funds and Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest
2Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk. 
3Active portfolio management, including market timing, can subject longer term investors to potentially higher fees and can have a negative effect on the long-term performance due to the transaction costs of the short-term trading. In addition, there may be potential tax consequences from these strategies.  Active portfolio management and market timing may be unsuitable for some investors depending on their specific investment objectives and financial position. Active portfolio management does not guarantee a profit or protect against a loss in a declining market.
4Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The Standard & Poor’s 500 (S&P 500) Index is a free-float weighted index that tracks the 500 most widely held stocks on the NYSE or NASDAQ and is representative of the stock market in general.  It is a market value weighted index with each stock’s weight in the index proportionate to its market value.
The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded “blue chip” stocks, primarily industrials, but includes financials and other service-oriented companies. The components, which change from time to time, represent between 15% and 20% of the market value of NYSE stocks.
5Risk tolerance is an investor’s general ability to withstand risk inherent in investing. The risk tolerance questionnaire is designed to determine your risk tolerance and is judged based on three factors: time horizon, long-term goals and expectations, and short-term risk attitudes. The adviser uses their own experience and subjective evaluation of your answers to help determine your risk tolerance.
There is no guarantee that the risk assessment questionnaire will accurately assess your tolerance to risk. In addition, although the advisor may have directly or indirectly used the results of this questionnaire to determine a suggested asset allocation, there is no guarantee that the asset mix appropriately reflects your ability to withstand investment risk.