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Model Portfolios Strut Their Stuff

Learn how they differ from mutual funds.

Tom Lauricella: Welcome. I'm Tom Lauricella, editor for professional audiences at Morningstar. And I'm speaking today with Jason Kephart, strategist at Morningstar, about our model portfolio research.

Jason, thanks for being here today.

Jason Kephart: Thanks for having me.

Lauricella: Let's start with an overview of model portfolio research. This is a relatively new area at Morningstar. It's a relatively new area in its current form for the industry, for advisors. As just a starting point, how does our research and how does the process for model portfolio research compare or contrast with traditional mutual fund research?

Kephart: That's a great question. The vehicle, the model portfolio, is a little bit new. But for the most part, we're evaluating them the same way we would evaluate any asset-allocation mutual fund or a target-date fund. We're looking for things like the quality of the underlying investments. We're looking at how well they fit together. The portfolio construction part is really important to us. And we're also looking at if the manager's trying to add any tactical trades over time--what that process is and if we're confident it could add value over time.

Lauricella: Now, there is one really big difference between model portfolios and mutual funds, which is that we don't have actual performance numbers for these, right? These are hypothetical, essentially, right? Based on the strategies that the asset managers lay out, we don't have real actual day-to-day performance numbers based on a portfolio the way we do with the mutual fund. What sort of challenges does that present for advisors trying to assess which strategies have been doing well or not doing well?

Kephart: I think it creates an extra layer of due diligence for the advisor or anyone trying to research model portfolios. I think you really want to get comfortable with whether or not the returns that are reported match up to what the portfolios reported are. If we see a long string of returns, without portfolios to match them up to, I would treat that as bit of a yellow flag and wouldn't put too much weight on that performance track record. You can still evaluate the quality of the underlying and how well they fit together. But I think in terms of evaluating past performance, you really have to have that portfolio along with the returns to make sure that they're within reason and they're not just really out of whack. Because, obviously, there's always the chance that someone could be reporting back-tested returns that might not be really realistic going forward. So you want to really be comfortable with when that track record really began. And you can really do that with portfolios.

Lauricella: And there's another element here, which is that ultimately the returns that a client gets is based on how the advisor actually puts these strategies to work, how they actually implement them in terms of trading and decision-making, right?

Kephart: That's kind of the key difference, I guess, between a model portfolio and a mutual fund. In the model portfolio, an asset manager or an ETF strategist is giving you recommended underlying funds, recommended asset allocations, and recommended trades, but it's on the advisor to either do those trades himself or find some kind of technology to help them like an auto-rebalancer. The asset manager's not going to be doing the trading for the advisors. And that's kind of the key differentiator--that the advisors at the end of the day retain discretion over the underlying funds.

Lauricella: As we were speaking earlier before we did this interview, you were mentioning that another aspect of this is that perhaps if an asset manager was implementing some of these strategies in-house, they might use more-sophisticated vehicles to implement them, derivatives, other aspects of it, that might translate into some different kinds of performance or different characteristics. Can you just talk through that a little bit?

Kephart: In model portfolios, one of the goals asset managers have is to make them kind of simple and straightforward and easy for an advisor to manage, given that the advisor is the one who has to implement them. T. Rowe Price is a good example. In their asset-allocation mutual funds, which are managed by the same team that oversees their asset-allocation models, they have a much broader line of underlying funds. It's around 14 or 15. They also use derivatives like equity futures or interest-rate swaps to alter the portfolios' exposures. But in the models they did, they're obviously not going to tell an advisor to go out and buy an S&P 500 future. So, they have a more slimmed down lineup. It's more like eight funds, so it's more manageable, but then the tactical tilts, like if they like emerging-markets equities, you have to overweight the emerging-markets equity fund rather than choosing a derivative to get that exposure in a quicker, faster way. But that's one of the trade-offs with having the advisor be the one that retains the ultimate discretion.

Lauricella: Sure. Let's talk about how this translates into some ratings for different managers. We'll start with two of our gold-rated model portfolios. Let's start off with Vanguard. They're the most simple ones out there, right?

Kephart: Yeah, simple and very cheap. The expense ratio for the Vanguard core models that we rate Gold range from about 4 to 8 basis points, and for that low cost, you're getting broad exposure to global stocks and bonds in a very reasonably put together portfolio. The stocks and bonds tend to complement each other very well. They're very high-quality bonds. So when equity markets don't do well, the bonds provide a very reliable ballast. So we think it'll give investors a very smooth ride over time. And given that they're just so cheap, it's just hard to find a real deficiency in them. They're probably never going to be the optimal portfolio, but they're always going to be a very good starting point and should be very durable over the long haul.

Lauricella: And another Gold-rated set of strategies comes from BlackRock. They're at the opposite end of the spectrum, right?

Kephart: Yeah, they're a bit more active. They're still using low-cost ETFs. But rather than just trying to get you broad exposure, they're being a bit more thoughtful about it. They take more granular views. They'll make sector overweights. In the beginning of 2020, we saw them add ESG as a strategic weight to the portfolios. And they're not trying to make the whole portfolios ESG intentional, but they just saw an opportunity there to kind of diversify the portfolio by adding companies that have lower ESG-related risks. Things like less energy, less oil sensitivity. So they added them to the portfolio for those reasons. And I think they just take a bit more thoughtful approach to building each portfolio on its own. What we've seen at a lot of firms is they'll take one portfolio, make a 60/40 fund, they'll scale it up or down. BlackRock is actually looking at the conservative portfolio and building a portfolio that makes most sense for that. And they're doing it for the moderate. They're doing it for the aggressive. So I think it's just we really appreciate the thoughtfulness that goes into it. And we think they're going to serve investors well, too.

Lauricella: Great. And then one more set of portfolios to talk about is American Funds. We rate them as Silver. What do we like about them?

Kephart: American Funds kind of falls in the middle, in a sense, between the Vanguard and BlackRock models. They are using active funds, but they're not doing a lot of tweaking at the top-down level. They're not going to tell you to overweight American Funds Growth Fund of America this month or American Funds New World this month. But there's a lot of activity going on underneath the funds. You are going to get some tactical tilts through the portfolios, but they're going to be driven by the underlying managers, which we think makes a lot of sense. And it also makes it a lot easier to use for an advisor because you're getting a lot of active exposures. But the advisor really doesn't have to be too active themselves to get the benefit of that.

Lauricella: Fantastic. We look forward to more research on this space. Jason, thanks very much for being here today.

Kephart: Thanks for having me.