Strategizing for Success with Model Portfolios

Understanding key objectives in effectively utilizing model portfolios

Once you decide to integrate model portfolios into your advising practice, what’s your next step? That will depend greatly on two important factors. The first involves understanding the types of model portfolios you can utilize and how they differ. The second is analyzing the key objectives of each type and how those objectives impact portfolio development: taxable versus tax aware; strategic or tactical. Let’s begin by taking a closer look at these objectives and how they can affect which type of model portfolio you decide to implement.

Differentiating between Taxable and Tax Aware models

In developing model portfolios with taxable and tax-aware considerations, keep in mind what you’re trying to achieve. Understanding the objectives for each portfolio type, as well as your clients’ investment goals will aid your decision making. 

When selecting tax-efficient investments for taxable and tax-aware model portfolios, the frequency of rebalancing¹ and fixed income allocations are important factors to consider.

In taxable model portfolios, rebalancing can generate taxable events, (i.e., capital gains) that can potentially increase a client’s tax liability, so it’s applied more judiciously, such as annually or semi-annually.  

Tax-aware model portfolios take into account tax implications, so strategic rebalancing is more aggressively utilized with the objective of managing taxable events. Thus, depending on market conditions, rebalancing may be utilized more frequently.

When it comes to allocating fixed income investments, taxable model portfolios typically generate interest income that’s subject to ordinary income tax rates. Thus, the balance between fixed income and other asset classes should be considered carefully. Conversely, tax-aware models intentionally account for the tax ramifications of fixed income allocations, utilizing assets like municipal bonds or tax-managed funds to manage tax liabilities.

Strategic model development

Strategic model development depends on various factors, including the investment firm’s approach, the complexity of the model portfolio, and specific investment objectives. Purely strategic models are formulated based on long-term capital market assumptions.

There are several reasons for this: 

• It allows for a reasonable assessment of investment opportunities and risks over an extended period that can span multiple market cycles.
• It gives you enough time to incorporate expectations for economic conditions, market trends, and asset class performance, allowing for a clear assessment of these factors. 
• A long period for capital market assumptions helps smooth out short-term market volatility and provides a more stable foundation for portfolio construction.
• It lets you make a comprehensive assessment of the risk-return characteristics of various asset classes, which is essential for constructing a well-diversified portfolio and managing risk effectively.
• Comparing the actual portfolio returns against the long-term assumptions lets you assess the effectiveness of the strategic model and make adjustments if needed.

Modern Portfolio Theory is an important underpinning in building strategic models, providing a systematic approach to determining the asset allocation required to achieve the desired risk-return tradeoff.

By diversifying investments across different asset classes, it enables you to help investors build portfolios that effectively align with their risk tolerance and return preferences.

Which clients benefit most from strategic models? Generally, they’re a good fit for those with a “hands off” approach to investing, with long-term investment horizons, a tolerance for some level of volatility, and who prefer a diversified approach. Financial professionals recommending this model should also consider capital appreciation, risk management, capital preservation, among other objectives. As always, clearly understanding client expectations will be a critical factor.

Tactical model development

Tactical model portfolio development is a more dynamic approach to investment decisions. Instead of utilizing a long-term fixed asset allocation, allocations are actively adjusted more frequently, based on short-term market conditions, and investing opportunities. 

• Economic indicators, market trends, and valuation metrics are assessed to determine weighting of certain asset classes to capitalize on opportunities or manage risks.
• While strategic models typically span multiple market cycles and years, tactical models may be adjusted more frequently, ranging from months to even weeks.
• Tactical models are designed to adapt to changing market conditions, and portfolio managers make adjustments quickly based on their experience and market insights. 
• Monitoring and evaluation are critical, with the performance of the tactical portfolios regularly compared to their benchmarks or peers. Ongoing analysis informs adjustments over time.
• Market timing² and identifying optimal entry and exit points for specific asset classes, though challenging, are critical components in building tactical model portfolios.

Short-term market movements can be unpredictable, so clients who opt for tactical models should be made aware of the potential for higher transaction costs, increased asset turnover, and the need for active monitoring. Because of these factors, tactical models are best suited for investors who have a higher risk tolerance, shorter investment horizons, and prefer active management in their portfolios. 

Manager-selection model development

Some financial professionals choose to have models constructed and managed by a professional investment manager rather than being based on a predetermined investment strategy or asset allocation. Ultimately the goal is to identify managers who add value by demonstrating expertise, consistent performance, and align well with the desired investment objectives.

Applying both quantitative and qualitative analyses is central to assessing the investment managers under consideration. Universe screening is the initial step. Financial professionals identify a broad set of potential funds³ or managers that meet criteria – asset class, investment style, and performance benchmarks – then narrow down to a more manageable pool for evaluation.

Quantitative fund screening empirically evaluates funds within the universe, examining historical performance, risk-adjusted returns, volatility measures, and expense ratios, shortlisting select funds for further evaluation. Qualitative screening then assesses the fund manager’s investment philosophy, research process, risk management, team expertise, and track record. Qualitative factors, such as investment approach, organizational stability, and cultural fit, are also considered. Fund selection is then initiated with the goal of identifying funds that have shown consistent performance, strong risk management, and an investment approach congruent with client needs. Once the funds are selected, financial professionals decide on the inclusion of select funds in their recommended portfolios, combining them into a portfolio that aligns with the clients’ objectives, risk tolerance, and time horizon.  

Throughout the process, the performance and activities of selected funds and fund managers should be continually monitored with regular reviews conducted to ensure that the selected funds continue to meet the desired criteria.

Success depends on clarity

No matter which model portfolio type you choose to implement for your clients, the single most important factor is being aligned with them on their investment goals and individual circumstances. Each type brings a variety of strengths and advantages, as well as tradeoffs that must be taken into consideration. Taxable model portfolios help manage losses and preserve capital but manage losses at the expense of opportunities for potential gains. Tax aware models rebalance more frequently to take advantage of market conditions but may add more costs as a result. Strategic models are good for investors that prefer a “hands off approach,” but are long term plays that call for patience. Tactical models aggressively seek out market opportunities with the potential for higher gains but come with more risk as well.

Carefully assessing clients’ individual circumstances, risk tolerance and investment goals will play a major role in determining your success. No matter which choice you make, open and honest communication as well as a clear understanding of client expectations should always rule the day.

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^{1 Rebalancing/Reallocating can entail transaction costs and tax consequences that should be considered when determining a rebalancing/reallocation strategy. Neither 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.}

^{2 Active 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.}

^{3 Mutual 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.}