Previous generations turned to financial advisors mostly for stock picking. Later, advisors began custom crafting portfolios using mutual funds.
That era of laser-focused attention on custom portfolios was a far cry from today’s emphasis on planning and asset allocation. This industry-wide shift means customized portfolios are becoming less important, while model portfolios are used more often.
Model portfolios are constructed with a diversified blend of stocks and bonds. They’re also designed to accommodate various levels of risk tolerance.
In addition to diversification and risk mitigation, model portfolios generally offer automated rebalancing and often a third-party management team, with extensive research and analysis capabilities.
“Model portfolios are the Ikea furniture kits of investing. If you want a certain uniform standard, they can be a reasonably reliable choice. However, if you’re looking for exceptional craftsmanship or customization, that’s not really what they’re designed for,” says Richard Barrington, senior financial analyst at MoneyRates.com.
The standardization of model portfolios has some merits, he adds.
“It can be a form of quality control, reducing the client’s exposure to mistakes or poor judgment on the part of their investment advisor,” he says.
Barrington also points out model portfolios’ limits.
“Model portfolios are generally constructed based on the historic risk-reward characteristics of their component parts,” he says. “This entails an implicit assumption that past performance will repeat itself in the future. Something that investment professionals are supposed to advise their clients will not necessarily be the case.”
In other words, past performance is not a guarantee of future results.
ETF Model Portfolios
Linda Zhang is a senior advisor to SoFi and CEO of Purview Investments in New York. Purview, which specializes in global investing and impact investing, developed its own ETF model portfolios.
The firm’s ETF model portfolios fall under the category of environmental, social and corporate governance investments ( ESG). These three factors are widely used to gauge the sustainability and environmental impact of an investment.
“There are two reasons we use Purview Investments’ climate-resilient ESG ETF model portfolios,” says Zhang, citing the environmental/social impact and active management.
“We could not find other models with the same depth of impact on climate resilience and social equity,” she says. “Purview’s suite of models also utilizes actively managed asset allocation strategies. Most model portfolios in the marketplace tend to use the generic ESG ETFs, without active asset allocation decisions.”
These asset allocation decisions also factor in constructing models for different risk-tolerance levels. Within broader asset classes, models incorporate various sectors and industries.
Stephen Taddie, managing partner of Stellar Capital Management in Phoenix, says model portfolios are the vehicle to achieve economic sector and industry weighting and security selection.
Within that framework, he says, “We integrate a client’s risk profile and income goals, with smart tax management strategies to decide how closely we can get to our desired model. We maintain a few internal models that are continually evolving based on our outlook that are designed to achieve different objectives.”
Trading Has Tax Consequences
Taxable accounts pose a bigger challenge than qualified accounts for all advisors using models. There can be serious tax consequences when selling securities with large capital gains. Advisors need to tread carefully and consult with clients if they plan to sell some of these positions and move the account into a model.
“It is more difficult to manage taxable accounts because the emphasis is on after-tax return, and how assets can eventually transfer in a tax-efficient manner to heirs,” Taddie says.
“Of the existing taxable portfolios that have been brought to us to manage over the years, I have seen some take many years to get to close to our desired weightings,” he says. “Others are continual work in progress due to the extent of unrealized gains, the tax-paying appetite of the client and the age of the client, or how close the client’s family is to being able to use the step-up in basis feature of the current tax code to transfer assets to heirs.”
Taddie is referring to the tax advantage for heirs who inherit an account. In those cases, securities are valued as of the previous account owner’s death. That makes it easier for the inheritor to sell out the portfolio with fewer capital gains tax consequences.
Organizing and Streamlining Subaccounts
Account customization is another issue advisors face when implementing models. Many clients are happy with some assets in a model, but simply want customization in other accounts.
Myron Mitchell, president of Mitchell Wealth Management Group in Winston-Salem, North Carolina, uses a portfolio accounting system to get various accounts organized and streamlined. This allows him to create separate subaccounts within any given client’s investment strategy.
“With these capabilities, we can mix and match investment models with other investments tailored to the client’s needs,” he says. “This allows us to better align a client’s investment program with client-specific goals, such as spending targets around various time horizons and overall risk tolerances.”
While Mitchell is among attentive advisors using systems to avoid costly reallocation mistakes in client portfolios, clients should be sure they understand an advisor’s process when using models.
“Some firms use models as a method to cram everyone into a system that is most efficient for the manager,” Taddie says. “My experience with high-net-worth clients shows they are better served with a more customized approach.”
Ultimately, it should come down to what is best for the client. “The client expects us to have a point of view regarding the best position for a portfolio and (for) us to integrate that point of view with their needs,” he says.
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