Model Portfolios for Investment Management: The Key to Efficiency?

Posted by Duane McDonald, ChFC, AIF

September 23, 2015 at 1:30 PM

model portfolios for investment managementEfficiency is the key to growing a successful fee-based practice. But the more new assets you bring in or convert to fees, the more time consuming it becomes to invest and manage them. Outsourcing investment management is an option, but many advisors prefer to have more control over their investment portfolios. If you fall into the latter category, what can you do?

Here, I'll compare the various available options, including the use of model portfolios for investment management.

What Are Your Options?

If you'd like to manage investment assets yourself, you generally have two choices:

Option 1: Custom. With this strategy, as each new client gives you money to invest, you build a customized allocation of investments based on his or her unique needs, as well as your latest product research and take on the markets.

  • Nearly every client account holds different investments in unique allocation amounts.
  • Each account is traded and rebalanced individually.

Many advisors run the investment side of their business according to the custom option. But this entails a huge time commitment, and little scalability or efficiency can be gained for the investment management process.

Option 2: Standardized. Here, you can build standardized allocations that are suitable for most client investment needs. This requires you to:

  • Perform ongoing due diligence on fewer products that complement one another
  • Use many of the same investment products across different models in varying percentages
  • Apply your tactical decisions across all models
  • Trade and rebalance multiple client accounts at one time

This option is the choice of many professional money managers. They have expertise in a particular investment process, and each account is invested in the same manner. This standardization allows them to manage large amounts of assets efficiently, make changes at the model level, and trade all the accounts at once to reflect the model change. Nonetheless, it is a customized solution, as one money manager's portfolios are distinct from another's.

Sound interesting? If so, where should you begin?

Build Model Portfolios

Don't reinvent the wheel for every client who walks through the door. Instead, select the predetermined model that best fits his or her financial objectives and risk tolerance.

Model portfolios allow you to:

  • Have consistent client interactions
  • Optimize efficiencies and systematize your processes
  • Delegate responsibilities as you grow your fee-based practice
  • Reduce the number of investments you track
  • Spend more time with clients and prospects

As you screen funds for inclusion in your models, pay close attention to each fund's investment history and merits. For example, Commonwealth's Investment Management and Research team considers macro and relative valuation metrics, as well as our own market outlook, to build model portfolios for a variety of client investment objectives and asset levels. Other items you might consider include ticket charges, 12b-1 fees, and fund minimums.

Hone Your Models

Now that you have some asset allocation and investment ideas, the next step is to back-test how your models have performed historically. One of the easiest ways to do this is to build your model portfolios in Morningstar® Advisor WorkstationSM. To do this:

  1. Put together a spreadsheet of your models.
  2. Input those models in Morningstar. (We like to use $100,000 for the model portfolio size.)

Once your models are in Morningstar, you can then run various portfolio and security analysis reports to back-test the performance and volatility of the allocations you've created. After optimizing the portfolios you'd like to use with clients, simply transfer them into your portfolio management software and assign appropriate client accounts to the models.

The Commonwealth solution. We've simplified this process for our affiliated advisors with our Practice360°® Models application. Advisors can build models from scratch or use preexisting templates and then manage assets on our fee-based asset management platform. With this online tool, advisors can monitor portfolio drift and place trades in seconds to rebalance accounts and bring them back in line with the model.

Establish Rebalancing Procedures

Rebalancing is a key component of any solid asset allocation program. It should be performed for every fee-based account and will become more time-consuming as you grow your fee-based business. Indeed, it's essential to develop a defined strategy for rebalancing model portfolios from the start.

It's also important to communicate the purpose of rebalancing to your clients and prospects—whether it is to improve performance, reduce risk, or both. And you'll want to set the expectation that regular rebalancing is part of your investment management process.

Keep in mind that your rebalancing strategy doesn't need to be complicated. But a good rebalancing policy should specify:

  • When you plan to rebalance
  • The tools and tactics you will use
  • Who is responsible for rebalancing

Step 1: Establish your rebalancing schedule. When should you rebalance? Most advisors prefer calendar rebalancing—quarterly, semiannually, or annually. Annual rebalancing is the most common, but you can also base the timing on your client service levels. Maybe you rebalance larger accounts quarterly or semiannually, and smaller portfolios get annual rebalancing. Whatever the timing, be sure to document the schedule in your procedures manual.

Step 2: Decide on the rebalancing threshold. If one asset class is out of balance by 2 percent, should you rebalance? Many advisors use a threshold of above 3 percent or above 5 percent. You can also use a dollar amount as the threshold to limit smaller transactions and unnecessary costs. Again, this threshold should be detailed in your procedures manual.

Other rebalancing factors to consider include:

  • Taxes. Selling assets can generate capital gains and losses—but understanding your client's tax situation will give you the time to offset any gains before year-end. You may also need to develop procedures specific to retirement accounts.
  • Expenses. Rebalancing can generate costly transaction charges. A general rule is to rebalance only when the benefits outweigh the costs.
  • Alternative investments. Assets like real estate, managed futures, and hedge funds can pose a rebalancing challenge. You may have to reallocate around some of these illiquid asset classes.
  • Dividends. Should you reinvest dividends or have them go into the cash sweep account? By having dividends go into cash, you may be able to use the money to balance out asset classes and avoid selling off winners.
  • Withdrawals. Withdrawals can throw off your allocation. Try to plan ahead and leave money in cash to cover foreseeable withdrawals and your advisory fee. When you need to raise funds for a withdrawal, consider selling off overweighted positions to bring the portfolio closer to the recommended allocation.

Whichever strategies you choose, documenting your processes will help you apply your rebalancing strategy consistently across accounts.

The Bottom Line

The use of model portfolios for investment management is a process-driven strategy, allowing you to manage large amounts of assets efficiently. Using the strategies described here, it will also enable you to spend more time with your clients and prospects and, in turn, to grow your business with these quality relationships.

Do you manage your own model portfolios or do you outsource investment management? Are there particular rebalancing procedures you've implemented? Please share your thoughts with us below.

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