Ask Your Advisor These Questions Before Investing in Custom Model Portfolios

Key Takeaways

• An advisor has three options when it comes to building a portfolio for their clients: They can build it by themselves, they can use an already premade model portfolio from an asset manager, or they can create a blend of both.
• Customization work tends to happen more upfront, whereas if you’re building your own portfolio from scratch, the ongoing maintenance and ongoing investment ideas are all on the advisor.
• When it comes to whether a custom model portfolio is the better choice, I think it depends on how strong your beliefs are and if you want them reflected in your portfolio. If that’s so, then customizing a prebuilt model could help.
• The most common customization is ticker swaps.
• Investors should also ask their advisors how far away the custom model portfolio strays from the model because there is a chance that it won’t behave as you expect.
• Custom model portfolios can have higher expenses, but they aren’t super expensive.
• Using a custom model portfolio can change an investor’s portfolio in unexpected ways. For instance, there could be unexpected consequences by adding index funds to an otherwise all-active portfolio.
• Keep an eye on the bonds in model portfolios, because it’s easy to look at bond-fund returns and fall in love with the higher-returning, higher-yielding ones, but typically those come with more credit risk.
• When it comes to adding alternative investments, if you add too crypto, the portfolio basically becomes a crypto fund with a 60/40 attached to it.

Susan Dziubinski: I’m Susan Dziubinski with Morningstar. Custom model portfolios are gaining traction with financial advisors, and as a result, you may soon hear about them from your financial advisor, if you haven’t already. What are the advantages of custom 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 a senior principal with Morningstar’s multi-asset team and co-author of the paper, “Morningstar’s Guide to Customizing a Model Portfolio.” Great to see you today, Jason.

Jason Kephart: Thanks for having me.

What Is a Custom Model Portfolio?

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

Kephart: An advisor really has three options when it comes to building a portfolio for his clients or her clients, and that’s either they can build it by themselves, they can use an already premade model portfolio from an asset manager, or they kind of do a blend of both, and that’s kind of that gray area in between that we kind of refer to as custom model portfolios.

Why Would Advisors Want to Customize Investment Model Portfolios?

Dziubinski: This might be a silly question, but part of the attraction of model portfolios is that they’re sort of these off-the-shelf solutions for advisors. So, why would an advisor want to customize that? Doesn’t it lose some of its allure for the advisor?

Kephart: I think the customization work tends to happen more upfront, whereas if you’re building your own portfolios from scratch, that’s kind of the ongoing maintenance, the ongoing investment ideas, that’s all on the advisor. But this way, they kind of do some changes upfront that maybe align with their beliefs, their clients’ beliefs, or preferences, anything like that. And then from there, the model portfolios are kind of set and forget it.

Are Custom Model Portfolios a Better Fit Than Model Portfolios?

Dziubinski: Got it. Then, is it fair to say that for most investors who, maybe, are faced with a custom model portfolio or a model portfolio that a custom model portfolio more often than not is the better choice because it has been tailored to their particular investment approach or time frame, or what have you?

Kephart: It could be. I think it really depends how strong those views are. Like, is it a make-or-break? Like, do you really want to have your favorite fund manager in there? Do you really want to have some tilts toward, maybe, valuation-sensitive areas? Or maybe you want to have ESG. I think it depends on how strong your beliefs are, and do you really want that reflected in your portfolio. And if that’s so, then maybe customizing one that’s already been kind of prebuilt, that could really help. There’s something called the Ikea effect, which also says that people, when they have a hand in building something, kind of feel more strongly about it, and the more you like your portfolio, the more likely you are going to stick with it through thick and thin. That’s really going to lead to the biggest changes in investor outcomes.

Custom Model Portfolio Examples

Dziubinski: That’s interesting. One question that investors should ask before investing in a custom model portfolio is how exactly that model portfolio is being customized for that investor. What are some of the most common customization techniques that advisors use in portfolios?

Kephart: I’d say the most common customization we’ve heard about is ticker swaps. And by that, I mean taking out one fund and replacing it with another. Like, maybe the model portfolio says, “Use an S&P 500 ETF,” but you feel really strongly about Will Danoff, and you want him to be the core US equity manager in your portfolio, so maybe that’s a swap you make. Maybe it’s on the bond side where there are a lot of big bond fund personalities out there, so maybe you feel a strong liking toward that. Mainly, it’s on the fund swapping side.

Why Investors Should Ask How Much Their Custom Model Portfolio Strays From the Model

Dziubinski: Investors should also ask their advisors how far away the custom model portfolio strays from the model. Talk about why that’s important.

Kephart: It’s important because if you’re going to start with a model portfolio that’s already been designed, if you go too far away from it, you’ve kind of built this own weird Frankenstein thing that, maybe won’t behave as you expect, and I think really the key with a portfolio is making sure it matches an investor’s risk tolerance and time horizon. And the more you kind of torture a model portfolio, the more it might not be able to deliver the way you expect. That’s just things to keep in mind, I think.

Why Custom Model Portfolios Can Have Higher Expenses

Dziubinski: Speaking of torture, investing in custom model portfolios can also have higher expenses involved with that. Is that right?

Kephart: It can. It depends if you’re adding more-expensive funds in place of cheaper funds. There could be platform fees that are involved. But, in general, we haven’t found that a custom model portfolio is really like a super expensive option.

Consequences of Customizing a Model Portfolio

Dziubinski: Using a custom model portfolio can change an investor’s portfolio in unexpected ways, and you talk about this in your paper, “The Guide to Customizing a Model Portfolio.” For instance, you say that there could be unexpected consequences by adding index funds to an otherwise all-active portfolio. What might those consequences be?

Kephart: I think you are taking a little bit of active risk off the table, and that can be a source of extra returns. But in general, the trade-off is going to be lowering fees. But I think, in general, if you think about an American Funds fund where the managers have a lot of flexibility in kind of where to invest geographically, switching out from something like that to a much more benchmark-focused index fund might give up some of the kind of pizzazz that was originally intended in the model portfolio.

Why You Should Pay Attention to Risk When Customizing Bonds in Your Model Portfolio

Dziubinski: Talk about what might inadvertently happen when customizing the bond sleeve of a model portfolio.

Kephart: I think the bond ones, the ones to keep an eye on, because it’s easy, I think, to look at bond-fund returns and kind of fall in love with the higher-returning, higher-yielding ones, but typically, that comes with more risk, more credit risk. And what we’ve seen historically, the last couple of years have been a little weird, but historically, credit risk and equity risk tend to be highly correlated when there are recessions. And if your portfolio takes on more risk in the bond portfolio, without really adjusting for that elsewhere, you might change that risk profile in drawdowns, which is when people are most likely to probably bail, and that’s what you don’t want to happen.

How Crypto’s Volatility Can Add Risk to Your Custom Model Portfolio

Dziubinski: Then, of course, there’s this idea of customizing a portfolio to include alternative investments, such as cryptocurrencies, and what’s to be mindful of here?

Kephart: I think with crypto in particular, it’s just such a volatile asset that what we found is adding even a small amount of it can really have a big impact on the overall portfolio returns. I think what we found is after you go over like 5% in crypto, all of a sudden, it’s like 10%, 20% of the volatility contribution. So, if you add enough crypto, it basically becomes a crypto fund with a 60/40 attached to it. So again, it’s just keeping your risks in line with what the client expects and what they want.

Top Custom Model Portfolios to Invest In

Dziubinski: All right, it’s time to name some names, Jason. Give us a few examples of model portfolios that can be customized that Morningstar thinks highly of.

Kephart: I think anyone who’s anyone in the model portfolio business is working toward customization now. And so even if models aren’t available today, I think they will be in the short term. But right now, BlackRock’s been kind of a first mover in that space. J.P. Morgan has made some advances. They’ve got some really interesting tax-management tech that could help transition a portfolio. That I think is usually a big barrier we see to adopting more model portfolios. I think Fidelity is making big changes here. American Funds, I think, we’ll hear from them a lot more going forward. I think it’s really all the big model providers you would think of are all going to have this option.

Are Custom Model Portfolios Adding Value for Investors?

Dziubinski: Got it. What’s Morningstar’s take overall right now on the concept of custom model portfolios? Do we think that they’re adding value for investors, or is it too soon to tell?

Kephart: I think it can go either way. But I think, in general, if you’re making moves that are better aligning with what your clients want and expect, then the more they like the portfolio, the more they are going to stick with it. And what we’ve seen is, obviously, you can’t time markets, and once people get out, it’s really hard to get them back in. So, having a portfolio someone could live with and sleep at night with, that’s kind of the key for them to reach their financial goals. So, if customization helps that, then we’re all for it.

Dziubinski: Jason, thank you for your time today.

Kephart: Thanks for having me.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch Ask Your Advisor These Questions Before Investing in Active Bond ETFs for more from Jason Kephart.