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What's The Buzz -Model Portfolios

What's The Buzz -Model Portfolios

April 04, 2024

While we normally address asset classes or economic/market data in these pages, today we’re going to do something a little different and address something that is increasingly making financial headlines – model investment portfolios.  

Model portfolios are a popular tool used by investment and financial advisors to help clients achieve their investment goals. These portfolios are designed to provide a diversified investment strategy that is tailored to the client's risk tolerance and investment objectives.  

According to a Bloomberg interview with Blackrock, the asset manager expects model portfolios to grow from their current $4.2 trillion industry to that of $10 trillion over the next five years. The adoption of model portfolios is clearly happening at an increasing rate. 

What Are Model Portfolios? 

  • Model portfolios are, essentially, portfolio templates designed by financial professionals to achieve specific investing goals for their clients.  
  • These portfolios consist of different asset mixes including stocks, bonds, and other investments across various industries. 
  • Managed by professional teams, model portfolios follow set rules and adapt based on market events. 

Benefits of Model Portfolios 

  • Diversification: Model portfolios provide a diversified investment strategy that can help reduce risk and increase returns. These portfolios cover a wide range of securities across different industries and geographic regions. 
  • Timesaving: Model portfolios can save advisors time and effort by providing a pre-designed investment strategy that is tailored to their clients’ needs. 
  • Cost-effective: Model portfolios can be more cost-effective than creating a custom investment strategy from scratch. As model portfolios are often created using exchange traded funds, they can be created with lower underlying expense ratios and tax-effective vehicles. 

One of the clear benefits that we recognize is the ability to allow advisors to focus on the entirety of their clients’ needs which is, often, much greater than just their investment portfolio. This is the reason that our group was formed inside Burrows Capital Advisors – it is our job to focus singularly on investing for client portfolios, which allows the financial advisors to focus on the many other needs of the client, from the simplest financial plan to the most complex estate planning. If a financial advisor is focused on their clients’ investment portfolio, they might be missing the forest for the trees – investment allocationis but one aspect of a robust financial plan. 

Naturally, there is no such thing as something that only has benefits to investors, there are always limitations. 

Limitations of Model Portfolios 

  • Lack of customization: Model portfolios may not be as customizable to a client's more complex financial objectives.  
  • Limited flexibility: Model portfolios may not be able to respond to changing market dynamics as quickly. 

 While we do not necessarily believe that model portfolios have limited flexibility, we are not aware of all model portfolios and therefore list it as a limitation. 

How are Model Portfolios Constructed? 

While we cannot speak about the construction of other model portfolios, we can speak about how we created our Longhorn series of ETF model portfolios and will use this as a basis for this discussion. While each model portfolio will be tailored to the risk profile associated with it (each model portfolio “maps” to a given risk profile, which is then compared to the client’s risk profile as determined by their advisor), they generally follow the same methodology: 

  1. As the model portfolios include and reflect the investment opportunity set, the “market structure” is determined. This step entails determining the allocation of the market to various asset classes such as equities and fixed income. The structure is determined by the market capitalization of indices representing these assets. 
  2. Within each asset class (equity or fixed income, for example) the “market structure” of that asset class is determined; this is the weighting of the “sub-asset classes”, such as how much of the equity market falls into international developed equities, how much of the fixed income market is comprised of corporate fixed income, etc. 
  3. Each “sub-asset class” is then further reviewed for its attributes such as yield curve positions in the case of various fixed income sectors. Growth, value, and market capitalization are examples of some equity attributes.  
  4. Once the market structure is determined, we apply our longer-term capital market expectations in order to arrive at “target weights” of each asset class and sub-asset class. 
  5. We then look at our shorter-term expectations (typically 6-12 months) and adjust target weights tactically, if opportunities to mitigate risk or increase returns occur. 
  6. In order to ensure client risk guidelines are adhered to, each sub-asset class exposure is given a “drift”, or amount of exposure variance that is allowed before rebalancing. Client guidelines help drive this “drift” as we do not want clients to have greater risk exposure than they are comfortable with. 
  7. Within this framework, risks are viewed in both a stand-alone sense (for example, equity market risk) and a correlation risk (for example, high yield correlation with equities and where the correlation is the highest), to ensure cross-asset correlations are considered.  These risks, along with others, will create the “portfolio risk” and affect weightings depending on the overall client profile. 

If only it were as simple as a 60/40 model portfolio sounds – 60 percent S&P 500, and 40 percent Bloomberg US Aggregate Index – rebalanced at some X frequency. If this were the case, however, there would be no need for groups such as Burrows Capital Investment Strategy, or any other model provider (assuming, of course, there are not models designed at this simplistic a level). 

What Should Investors Look for in a Model Portfolio? 

If an investor or client is looking at or being offered a model portfolio, they should look for the following information: 

  • What is the risk profile of the model portfolio?  
    • This will obviously vary according to the underlying assets and allocations. Is the risk consistent with your risk profile and investment objectives? 
  • Are there clearly delineated ranges for the various asset classes?  
    • If there are no ranges spelled out, there is the risk of “risk drift”, where the risk in the portfolio increases (or decreases) and is no longer consistent with your risk profile. 
  • Is the portfolio understandable or can its characteristics be explained in understandable terms?  
    • We believe that you should always understand what is in the portfolio and, importantly, how it works. If you don’t, someone should be able to explain it to you in an understandable way. 
  • What benchmark is it designed to track and why? 
    • Understanding the market benchmark, such as the S&P 500 Index for equities, gives you a better idea of how the model portfolio is managed; the portfolio should not stray too far from the manager’s benchmark unless it is disclosed that it will or explained that it will.  
  • Are there “preferred products” (securities or funds issued by the model manager) included? 
    • To be clear, this is not necessarily a negative attribute, but one that should be understood. 

The bottom line is that model portfolios can help many people invest in a relatively straight-forward and understandable way.  Once the “true” risk profile is ascertained, a model can be deployed that matches the risk profile.  For some people/investors, a model portfolio will not meet their needs due to specific needs such as asset class exclusions, investor specific preferences, or investment policy provisions.  Like everything market related, there is a time, place, and investor for everything, and the investor needs to understand what fits them the best. 

Disclaimer:

The views expressed in this publication are those of the author and do not necessarily reflect the views and opinions of Cetera Advisor LLC or Burrows Capital Advisors.

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A diversified portfolio does not assure a profit or protect against loss in a declining market.