Model behavior: The evolution of the total portfolio

More advisors than ever are using model portfolios to manage their clients’ investment strategies. Martin talks to BlackRock’s Eve Cout to find out what’s behind the trend.

What matters most for long-term investors? Is it building a portfolio of top-performing stocks, or just being in the markets with a good blend of stocks and bonds? If you chose the latter, take a bow.

In fact, there are two important determinants of long-term performance. The first is simply time in the market – maintaining the discipline to stay invested even during rough patches. The second is asset allocation, choices about the mix of stocks and bonds.  Although scholars have tortured the topic of how much impact these decisions have — with various studies citing anywhere from half to almost all of a portfolio’s return — the point is that they’re too important to be ignored.

And yet, for decades stock-picking dominated the investment management business. My own stock-broker grandfather would build portfolios of 15 to 20 stocks for his clients, with the understanding that his work constituted just a part of a diversified portfolio; other professionals would manage clients’ savings and bond holdings.

That mindset has shifted, as more investors look to build total portfolios instead of treasure-hunting for winners. The evolution has been driven in large part by technology. Much as apps pinpoint restaurant recommendations based on our location and preferences, investors can now use sophisticated model portfolios to get an asset allocation that effectively targets their desired outcomes, risk tolerance and other preferences.

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Today, there more model portfolios than there are mutual funds.[1] What’s behind their popularity? Here’s what Eve Cout, who leads model portfolios for BlackRock’s U.S. wealth advisory business, has to say.

Martin: Let’s start by defining model portfolios and describing the size of their universe.

Eve: The term “models” is used in different ways, but what we’re usually referring to is a pre-fixed asset allocation portfolio that’s globally diversified across 10 to 12 funds. They’re typically created by financial advisors, wealth management firms or asset managers like BlackRock.

In terms of size, BlackRock estimates that some $2.7 trillion of assets are being managed in model portfolios by advisors.  That’s roughly equivalent to 12% of the $21 trillion in mutual funds, ETFs, closed-end funds and other registered investment companies in the United States, according to the Investment Company Institute.

Martin: I think of models as guardrails around asset allocation. Would you agree?

 Eve: Absolutely!  Model portfolios not only serve an investment function, by aligning an asset allocation to your goals and risk appetite, but I think there’s an important psychological component as well. Because models are fixed and available with very low minimums, they make it easier for people to get in – and stay in –the markets. The convenience of the experience can add the discipline and focus needed for long-term success.

Martin: Model portfolios have been around for a while, but in recent years we’ve seen a big leap in their use by advisors and their clients. Why do you think they’ve become so popular?

Eve: I see two big trends at play. One is that advisors are increasingly providing more than investment management. They’re seeking to add value with financial planning services, estate and tax planning, saving for college and paying off debt. Models let advisors outsource the investment process to professionals and spend more time going deeper with clients.

The second trend is technology, which has made models more accessible than ever. They’re easier to build, customize and implement. Likewise, in a single statement clients receive the depth of information that’s normally reserved for institutional or very wealthy investors.

Martin: Let me ask a potentially uncomfortable question. Is it “cheating” when an advisor or asset manager uses models? After all, we pay them to manage our money.

Eve: Keep in mind that advisors are responsible for more than choosing an asset allocation. They need to understand their clients’ goals and risk appetites; as these change, so should the allocation. An advisor should also revisit an allocation annually to ensure that it’s consistent with a broader financial plan that includes things like emergency savings.

Importantly, the variety of available models makes it possible for advisors to customize strategies for client outcomes that range from retirement income to factors to tax awareness. There’s nothing “cookie cutter” about them.

Martin: My final question is about questions. What should investors ask to better understand models?

Eve: Here’s what I would focus on. If you’re working with an advisor, ask if he or she uses models and, if so, how models work and how you’ll monitor progress. If you’re investing on your own, start with the outcome you’re seeking. Then, pay attention to the model providers. Are they familiar to you? Is the portfolio cost-effective, meaning are you getting good value for what’s in it? The answer may be contingent on whether they hold mutual funds, exchange-traded funds or both. Ultimately, it’s about consistency and transparency – you want to make sure there are ‘no surprises’ and know what to expect over time from a risk/return perspective.

Martin: That’s great. Thank you, Eve.  

Learn more about model portfolios.

Martin Small is the Head of U.S. U.S. Wealth Advisory and a regular contributor to The Blog

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