Comparing Target Risk, Taxable v. Tax-Aware, and Price Sensitivity When Selecting Model Portfolios
Among financial professionals, model portfolios have become all the rage of late – and with good reason. These versatile, time-saving tools are helping them serve more clients more efficiently, maintain consistency in investment strategies across their client bases, and protect clients from overexposure to any particular investment or asset class.
Yet even with their growth in the industry, there’s still some mystery about what model portfolios are and how to best utilize them. So, let’s look at what defines a model portfolio, and analyze some of the overarching themes which guide portfolio development and selection.
In their most elementary form, model portfolios are a series of predetermined asset allocations1 with a recommended mix of asset classes that are chosen based on a client’s risk tolerance. Over time, the portfolios are rebalanced automatically according to changing market conditions based on the respective investment team’s investment philosophy and approach. Typically, underlying holdings consist of a collection of ETFs, mutual funds2, or a combination of both to align with a particular investment objective.
Demystifying risk levels and client objectives in model portfolios
While there are various types of model portfolios, one staple is target risk models. These models are designed to align with objectives of investors with specific risk tolerances, ranging from conservative to aggressive.
Model portfolios can also be oriented towards client goals. A retirement-focused portfolio may have the objective of generating income and preserving capital. A more growth-oriented portfolio may concentrate on capital appreciation. Some investors may exhibit sensitivity to price, while others are more concerned with minimizing tax implications on their investments.
By providing your clients with a clear understanding of potential risks and returns associated with each portfolio type, financial professionals can help them choose one most aligned with their goals and preferences.
What are target risk models?
Often seen as a simple solution, target risk models offer an approach that considers the desired level of risk exposure for a portfolio. They can help financial professionals define and manage the risk profile of a portfolio by establishing a target level of risk that aligns with their client’s investment objectives and risk tolerance.
These models consider numerous factors, such as: investor goals, time horizon, risk appetite, and market conditions. A careful analysis of risk vs. return of the assets within the portfolio can help determine an appropriate allocation strategy to achieve the desired level of risk exposure.
Using a target risk model gives financial professionals a systematic approach to managing risk and maintaining a portfolio that aligns with the risk preferences and goals of their clients. But, of course, there are pros and cons to every approach.
Target risk models offer many advantages, such as:
- Personalization: Target risk models allow financial professionals to tailor the strategy to adhere to specific risk tolerance, investment objectives, and time horizons.
- Risk Management: Defining target risk gives these portfolios a framework for managing that risk. Financial professionals can make informed decisions about asset allocation, diversification, and risk-reward trade-offs to achieve their desired risk exposure.
- Consistency: These models offer a consistent approach to managing portfolios over time. They help financial professionals maintain a disciplined strategy by keeping risk levels within the predefined range, even as market conditions change.
- Clear Communication: Target risk models help financial professionals maintain clear communication with their clients by giving transparency and setting expectations.
- Flexibility: Target risk models still allow for the risk level of the portfolio to be adjusted. As clients change their preferences or goals, the portfolios can be adjusted accordingly.
It’s clear that these portfolios can offer a tremendous amount of benefits, allowing financial professionals to optimize their relationships with their clients. But there can still be limitations to consider, such as:
- Simple Approach: Target risk models can sometimes be too simple and therefore not capture all of the complexities and nuances of the client’s needs, which can limit their accuracy and effectiveness.
- Reliance on Historical Data: Many model portfolios don’t have longer track records so financial professionals might be relying on historical, simulated performance data.
- Limited Customization: Although these models are somewhat customizable, they still can be constrained by the predefined risk portfolios or asset allocation strategies. This can restrict from the ability to accommodate unique investment objectives or risk preferences that fall outside of the predefined framework.
- Performance Variability: The performance of target risk models can vary depending on the accuracy of the risk estimations, effectiveness of asset allocations, and overall market conditions.
Making sense of target risk models
In short, target risk model series typically refer to pre-designed portfolios designed to appeal to investors with different risk tolerances.
Low Risk Portfolios are meant for investors who prioritize capital preservation. They typically have a higher allocation to fixed income securities, which are generally less volatile than equities and may be suitable for investors with a shorter investment horizon.
Moderate Risk Portfolios are for investors willing to take on some risk for potentially higher returns. They feature a mix of fixed income securities and equities, with a higher allocation to equities relative to low-risk portfolios and may be suited for investors with a medium-term investment horizon.
High Risk Portfolios are designed for investors who will tolerate a higher level to pursue higher returns. As they have a higher proportion of equities relative to fixed income investments, they may be better suited for investors with longer investment horizons.
Specific characteristics will vary depending on the investment firm offering them, and factors such as diversification, asset allocation, and fees should be taken into account. In all cases, individual client risk tolerance and investment goals should guide recommendations.
Taxable v. tax-aware model approach3
Looking at models through a slightly different lens and considering client preferences beyond risk tolerance opens up taxable and tax-aware strategies for consideration. Taxable and tax-aware model portfolios are designed to optimize tax efficiency based on a client’s tax situation. So how is that achieved?
- Taxable model portfolios: Taxable model portfolios are designed with the implications of taxable gains tax in mind. The goal of a taxable model portfolio is to minimize the tax burden by considering factors like capital gains, dividends, and interest income.
- Tax-aware model portfolios: Tax-aware portfolios, though, optimize tax efficiency by integrating tax considerations into the investment management process. These portfolios not only aim to minimize taxes, but also take into account an investor’s specific tax situation, such as their tax bracket, holding periods, and potential deductions. These model portfolios consider factors like realizing long-term capital gains, offsetting gains with losses, and managing income distributions. They employ techniques like tax-efficient asset allocation, tax-sensitive rebalancing4, and using tax-managed funds or separately managed accounts (SMAs) to enhance tax efficiency.
Both taxable and tax-aware model portfolios strive to optimize after-tax returns for the investor by managing the impact of taxes on their gains.
A look at price sensitivity
Price sensitivity is another consideration financial professionals should be aware of when making recommendations to their clients. Price sensitivity should be considered when evaluating factors such as transaction costs, particularly when making adjustments within the portfolio.
Model portfolios most often are composed of assets such as mutual funds, or exchange-traded funds (ETFs). When making adjustments or rebalancing, you may need to buy or sell assets that have transaction costs associated with them. This typically takes place at the underlying holdings level, such as the expense ratio of the ETF. Another price consideration is overlay or management fees an asset manager or strategist charges to manage the portfolio. This typically occurs when the manager does not have underlying proprietary products within the model.
Being cognizant of price sensitivity with your clients is important when assessing the potential impact of these costs. Your client’s price sensitivity may inform the assets that you choose to buy or sell when adjusting a portfolio. In some scenarios, using mechanisms such as limit orders or algorithmic trading can help mitigate the impact of transaction costs.
A financial professional who considers their clients’ price sensitivity can potentially optimize the trade-off between expenses and portfolio performance.
Assessing your clients’ goals, preferences, and risk tolerance
While financial goals and preferences are somewhat clear cut, figuring out a client’s risk tolerance can seem vague and harder to measure. In fact, clients themselves may not be clear on how much risk they can live with. Still there are ways to get a better read that will help your clients understand their investment attitudes better and enhance your ability to serve them.
Risk can be defined in numerous ways, but not surprisingly, most clients would likely respond that they are averse to losing their hard-earned money. However, the real question is how willing are they to risk loss – and how much loss – for potentially higher returns?
Some clients couch risk in terms of potential for market losses. Others frame it in terms of what may happen if they lose a job, or other source of income, or have some sort of catastrophic event. But it’s also expressed in terms of FOMO – fear of missing out – on a lucrative investment. Asking frank questions, identifying a time horizon, and utilizing a risk-profiling questionnaire can help you evaluate a client’s risk tolerance5 – particularly their feelings about losing money. These factors, along with a clear-eyed examination of their goals, preferences, and current market conditions will help you decide which investing style you should employ and how to customize it for your clients.
A model solution?
Unquestionably, model portfolios offer a host of time and labor-saving benefits that can help you work more efficiently. While having transparency into investment objectives and portfolio construction, you can choose strategies that cater to your clients’ financial goals.
Still, choosing a model portfolio provider is a big decision and it pays to do your research. What types of asset allocation strategies are available, and which work best for your clients? What type of features and characteristics do the provider’s models offer? Which asset classes are available? How often are the models rebalanced? What is the fee structure? Finally, is your investing philosophy and work style congruent with that of your potential partner?
Model portfolios can be a real boon to time-strapped financial professionals, providing a consistent investment strategy that can be applied to multiple clients with similar investment goals. They can save time on research and analysis, are customizable to meet specific needs and goals of individual clients, and can aid in regulatory compliance. Adding them to your arsenal of resources can not only free you up for more important business-building activities, but can richly reward you in overall job satisfaction and improved client relationships.
1 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.
2 Asset Allocation does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
3 TIFIN does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstances.
4 Rebalancing/reallocating can entail transaction costs and tax consequences that should be considered when determining a rebalancing/reallocation strategy.
5 Risk 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 advisor 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.