Ask Your Advisor These Questions Before Investing in Model Portfolios

Key Takeaways

• A model portfolio is basically a recipe for how to build a portfolio.
• The types of model portfolios are most popular with advisors are your building blocks, mainly the core 60/40 type portfolio. We do see a lot of variations of how advisors use various allocation models like the 60/40.
• Outside of these allocation model portfolios, advisors are using income-focused models, all-equity models, all-fixed-income models. Some even do all US equity and international equities.
• Some of the advantages of model portfolios over other investment options for investors is that they’re usually like all-in-one solution and tend to be very low cost.
• One of the disadvantages of model portfolios over say straight mutual funds or ETFs is that there’s a little less transparency around it.
• Ask if your advisor is using a model portfolio. Then, ask about the track record and how the advisor is measuring success.

Susan Dziubinski: I’m Susan Dziubinski with Morningstar. Model portfolios have gained traction with financial advisors, and asset managers have flooded the marketplace with options. Given their growing popularity, you may soon hear about model portfolios from your advisor if you haven’t already.

So what are the pros and cons of model portfolios? How do they work? And what do you need to know about them before investing? Joining me today to discuss all of the above is Jason Kephart. Jason is Morningstar’s director of multi-asset ratings.

Good to see you, Jason.

Jason Kephart: Hi, Susan. Thanks for having me.

What Are Model Portfolios?

Dziubinski: Let’s start at the beginning. What are model portfolios?

Kephart: A model portfolio is basically just a recipe. Much like you would cook food, it gives you a list of ingredients. Those are your underlying funds. And it tells you how to put them all together. That’s your asset allocation. And it will also tell you how to trade it over time. But essentially, I always think of it, it’s basically just a recipe for how to build a portfolio.

Why Model Portfolios Are Attractive to Advisors

Dziubinski: Now, why are model portfolios attractive options for so many advisors these days?

Kephart: I think the biggest benefit for advisors is one, it frees up time. You don’t want your advisor to spend a lot of time stressing over, is the Fed going to cut 25 bps [basis points] or 50 bps? You want them working on your financial plan. The advisor also wants to work on growing their business. So outsourcing the investment management to a well-known firm that is pretty good at investing and does that full-time, that gives the advisor a lot of time to do other things that could really build more-meaningful relationships with their clients and also help them grow their business.

How Advisors Access Model Portfolios

Dziubinski: How do advisors access these models?

Kephart: There’s a lot of different ways. If you’re at a big firm, there might be what’s called a home office model, which if you’re at like a Merrill Lynch would be the model portfolio offered to all their financial advisors and filter down to clients. We’ve also seen a lot of growth in third-party models. This is models from asset managers that you’re familiar with, BlackRock, Vanguard, American Funds. So there’s really those two main ways, or an advisor can maybe build their own model portfolio for their practice and something that’s scalable across their clients.

Most Popular Model Portfolio Providers Outside of Home Office Models

Dziubinski: Got it. So, outside of those home office models, what are some of the most popular model providers?

Kephart: The most popular one by far is BlackRock. They’ve done a really good job capturing the advisor audience and doing a lot of things like building a lot of support around their model. So, regular commentary, regular market views. And it doesn’t hurt that they’ve also done a really good job managing them. The performance has been really solid. We think they’re really good.

Other ones that are really popular are American Funds. Vanguard has been very popular, which is kind of interesting because they haven’t really made as many inroads in asset allocation with financial advisors as these other firms, because Vanguard has always been so focused on the end investor, but really it’s made a lot more inroads with advisors more recently.

What Kind of Investments Are in Model Portfolios?

Dziubinski: That’s interesting. What types of investments are typically held in these models? Mutual funds and ETFs?

Kephart: Mainly mutual funds and ETFs. We’re seeing a lot more ETFs, and particularly, active ETFs. When we look at the model portfolio database at Morningstar, three years ago only about 100 models had even one holding of an active ETF, and now more than a thousand do. It’s a great way to get active management at a lower fee, and models, the other benefit of them, is that they tend to be really cheap. And ETFs also make them more portable. Mutual funds, right, you’re going to depend which platform you’re on. You might not be able to get the same one on Schwab as you do on Fidelity, but in ETFs you can access through anything. So it makes it a lot more flexible, I think, for the advisor.

Most Popular Types of Model Portfolios With Advisors

Dziubinski: Jason, what types of model portfolios are most popular with advisors, and why?

Kephart: The most popular ones are your building blocks, like the core of your portfolio. Think of the 60/40 portfolio as kind of a starting point. We kind of call them target risk. They target a level of volatility for a certain risk tolerance. So they kind of run the gamut from conservative to aggressive. We tend to see a lot of advisors focus on that core 60/40-type portfolio.

Asset-Allocation Models for the 60/40 Portfolio

Dziubinski: Walk us through some of these various allocation models, given that these seem to be the ones that are the most popular with advisors, right?

Kephart: They tend to be fairly similar across the board. There’s only so many ways you could torture a 60/40 to make it different, but we do see a lot of variations. Some will use alternatives, some won’t. Some are all ETFs, some aren’t. Some are much more long-term strategic asset allocations that will only shift maybe once a year, whereas others trade more frequently, four to six times a year.

Income-Focused Models

Dziubinski: Outside of these allocation model portfolios, what other types of model portfolios are out there that advisors are using?

Kephart: You can really make a model out of anything. The sky’s the limit, and there’s very little barriers to launching a new model. You don’t have to go through the SEC or anything like that. So we see a lot of product proliferation in the model space. But other things we see are income-focused models, all-equity models, all-fixed-income models. Some even do all US equity and international equity. So you kind of Frankenstein-together a bunch of different models to get one total portfolio. And you might even see all-alternative models. So really, whatever you can dream of, an asset manager’s probably already got a model portfolio for it.

Customization of Model Portfolios

Dziubinski: Now, are all of these models off-the-shelf, or are asset managers also offering advisors any sort of customization?

Kephart: We’re starting to see a lot more partnerships and customization with like large RIAs or wire houses where they might have certain requirements like: To be on our platform, you have to have at least 30% open architecture. Open architecture means funds that are managed by firms that are not the model provider. So if it was a BlackRock, you’d have to have 30% in Vanguard, Schwab, State Street, and other ETF providers. And it’s really just to make sure you’re not only getting one firm’s views in there. So there are benefits from that, but a lot of times, it could be a little bit of window dressing. But in general, we are seeing more customization, though, I think. There may be a large RIA that doesn’t want to give up Will Danoff. So the model provider will say, well, we didn’t have Fidelity Contrafund in there, but for you, we’ll put it in there and adjust things around.

Which Types of Advisors Are Likely to Use Customized Model Portfolios?

Dziubinski: Got it. What types of advisors are more likely to use these customized options? Is it the bigger firms?

Kephart: I think it’s the advisors who are more focused on financial planning. So they take more of a holistic approach to the client relationship. And it’s not really just dependent on financial performance of their investments. And I think that makes stickier client relationships. And you’re focusing on things like estate planning, your kids’ college savings, charitable giving, all these other things. Where investment performance, we know, no strategy is in favor all the time. So if the only thing an advisor has to offer you is investment performance, there’s probably going to be a period where that doesn’t look that good. And that’s going to, you know, could create some churn for both the client and the advisor, which is probably never a fun thing to do.

Advantages of Model Portfolios

Dziubinski: Now, what would you say are the advantages of model portfolios over other investment options for investors?

Kephart: I think one, they’re usually like all-in-one solution. They tend to be very low cost. A lot of the model providers that are the most popular are asset managers we think really highly of. We think really highly of the multi-asset teams at Vanguard, at American Funds, at BlackRock. So there’s a lot of good investments out there for people. And it does also give you direct ownership of the underlying funds. So this is one advantage you’d have over using like a Vanguard model over a Vanguard allocation mutual fund. In an allocation mutual fund, you just own a share of the mutual fund. But in a Vanguard model, you would own directly the four or five ETFs that make it up. So that could create some like more tax optimization. You could sell things at a loss, lock in gains, offset future gains. So you just have a little bit more flexibility in the model space.

Disadvantages of Model Portfolios

Dziubinski: Jason, what would you say are the disadvantages of model portfolios over, say, straight mutual funds or ETFs?

Kephart: I think one of the disadvantages, there’s a little less transparency around it. You can’t really look up a model portfolio on Morningstar.com per se, like you could a mutual fund. If you are a user of Morningstar Direct, as a financial advisor, you can see our ratings and star ratings for models. But I think for the individual investor, there’s a little opacity there. So it’s not as easy to look up past performance, manager turnover. So you’re going to rely on your financial advisor to do that due diligence for you. So there’s a lot of trust there, I think.

What Investors Need to Ask Advisors Before Investing With Model Portfolios

Dziubinski: What about some of the checklists that investors should have if their advisor is saying, “Hey, I want to start using model portfolios.” One of them, might be, hey, ask to look at the prior performance since it’s hard to access that, right? What would be some other things they should be asking their advisors for before investing in these?

Kephart: I think maybe the first thing would be, “Are we using a model portfolio?” Some advisors might not be as forthright to tell you the portfolio you’re in is actually a model they’re following. So that’s one thing I’d maybe start with. I’d also want to know, “How did you pick this model over other models?” Maybe, “What other models did you consider?” and “What did you see the pros and cons of those to kind of get a flavor of how much due diligence was done?” Then I think you want to know about the track record. Obviously, past performance is not indicative of future performance, but you want to make sure you’re checking out that you’re in something that has done well and performs like you think it should over different market environments. And I think the other thing to think about would be, “Well, how are you measuring success of this model portfolio? How do we know if it’s doing well or not? How would you, how are you going to measure that?” I think those are the main questions I’d want to ask my financial advisor.

Dziubinski: Well, thank you so much for your time, Jason. We appreciate it, and we’ll be talking to you more in the future about other things that investors might be hearing about from their advisors.

Kephart: Great, looking forward to it.

Dziubinski: Nice to talk to you. Thanks for tuning in. I’m Susan Dziubinski.

Watch What Falling Interest Rates May Mean for the 60/40 Portfolio for more from Jason Kephart.