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Due Diligence on Model Portfolios

Scott Burns

Scott Burns: Talking ETF model portfolios. Hi there, I'm Scott Burns, Morningstar's director of ETF research.

Joining me today is Michael Iachini, who is a director in Charles Schwab Investment Advisory Group. There Michael oversees a team of analysts who are looking at not only mutual funds but also ETFs for things like Schwab's Select List and also for Schwab's in-house model portfolio or wrap portfolio programs.

Michael, thanks for joining me.

Michael Iachini: Thanks Scott.

Burns: Michael, maybe you can talk a little bit about your role inside of Schwab, because I think, for the general public out there, you have a very large team. You play a very important role, a very important broker/dealer out there, but you're very much in the background a little bit.

Iachini: Yeah. Our group in the Charles Schwab Investment Advisory, we are in the background. We are not out there in the branches. But what we do is a lot of things that people in the Schwab branches are using with clients. So we put together Schwab's recommendable mutual fund list, like the Select List, very well known by our clients.

We are also in charge of Schwab Managed Portfolios, one is a mutual fund version, we also have an ETF version, and these are portfolios that a client can basically say, I want to hire Schwab to manage money for me. So you buy mutual funds or ETFs that are appropriate for me whether I'm aggressive or conservative or somewhere in between.

Burns: An area that's really come on to our radar at Morningstar lately has been this model portfolio or the wrap portfolio, as it's known. Is that an area that Schwab is really looking to grow business in right now?

Iachini: Yes. Schwab is definitely interested in these model portfolios, these wraps. We started our first one a little over four years ago. That was a mutual fund version, and then an exchange rated fund version at the beginning of 2010, and Charles Schwab Investment Advisory has been hired to run those and actually pick the funds. And it's something that a lot of clients want. It's really for the do-it-for-me client, who doesn't want to have to pick their own funds, rebalance their own account. That's really who Schwab was aiming for when they brought out this wraps. They've asked to manage those by picking good managers from mutual funds and by doing good management of the ETFs in the portfolio over the ETF version.

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Burns: Right. So it's kind of that all in one solution; take this and take the money and you'll buy the diversified portfolio, whether it's a mutual funds or ETFs…

Iachini: Exactly right.

Burns: …and keep that rebalance. You know, just out of curiosity, what is kind of the typical fee for one of these programs?

Iachini: It depends from broker to broker. At Schwab, they charge 50 basis points or half a percent for the mutual fund version, and then there's breakpoints for clients who have a lot of assets, and at 75 basis points or three quarters of a percent for the ETF version.

Burns: Right. And the ETF version, so it's 75 bps, and you also have to consider the fees for the funds as well, so just to make sure…

Iachini: Exactly. There's still underlying management fees on funds or in the ETFs.

Burns: Right. So this area has been really growing, especially in the ETF space. We find a lot of advisors who are saying, look, I don't want actively managed mutual funds anymore. I want to go the passive route with ETFs. But investing isn't really my forte. What I'd like to do is kind of outsource that forte. And we're seeing a lot of growth, I think, in these model portfolios that's happening right now. Some of it, or a lot of it, is actually happening off the grid a little bit. So, what advice would you give to an advisor who is out there looking at model portfolios for their clients, the due diligence process that's required to pick the right one for that?

Iachini: Well, as with picking a mutual fund or anything else, there is a due diligence process you have to go through. Part of it will be about fees. You certainly don't want to have excessive fees for your clients if you're hiring someone to manage a portfolio for them. But you also want to understand what is their process. So is this a manager who is more of a buy-and-hold approach? So they'll buy you a diversified portfolio of static ETFs and hold them forever. Or is there some kind of active management, either through mutual funds that they pick or actually active management of the ETFs.

If they are actively managing ETFs, overweighting certain sectors or countries or whatever that might be, how are they doing it? How do they reach the decision to overweight a particular part of the market and underweight something else? And can they explain that process and convince you that, yes this is why we have value for our clients and why we'll continue to be able to do well in the future.

Burns: Yeah and one of the things in that due diligence process that I think I see some other participants in the industry massaging a little bit, and I think kind of incorrectly, is the benchmark. Because when we talk about how are they doing, especially if they're doing more of a tactical allocation strategy--benchmarking to the S&P 500, although for many people that is the most well known benchmark--if you're looking at a portfolio that owns things like fixed income or international stocks or commodities, that's not really the appropriate benchmark because you have a full allocation portfolio. What benchmark do you guys use to evaluate how well you're doing?

Iachini: Well, it differs. For the mutual fund portfolios we do have a blended benchmark of U.S. stocks, international stocks, bonds, cash. And then for the ETF portfolios, it's a little bit of a simpler benchmark of just basically U.S. stocks, bonds and cash. And part of the reason there is, when you're managing a diversified portfolio like this, the people behind it are trying to show that over time if you're well diversified you'll probably have a smoother ride, fewer ups and downs than some of the more concentrated benchmarks might have. But it's definitely something that clients need to be aware of because you want to make sure you're benchmarking yourself to something that's appropriate.

Burns: Right. Well, Michael thanks for your insights today and your tips on that due diligence process.

Iachini: Thank you, Scott.

Burns: I'm Scott Burns. Thanks for joining us.