One of the most prominent developments stemming from wealth managers’ efforts to exert more control over portfolio construction is the move to model portfolios, where individual investments are selected and the asset-allocation methodology is applied in a way that meets the investment needs of investors with similar goals, risk tolerances, and time horizons. According to Broadridge, assets in models reached $3.5 trillion at the end of 2019, and growth through models is far outpacing investment product growth overall.
Given the large influx of flows into models in recent years, it is worth breaking down the model market to identify how the broader market is changing. The model market is divided into three segments based on where the model is controlled:
- Advisor-led models encompass everything from custom-built and managed portfolios to the use of model-construction tools that allow advisors to more efficiently build and rebalance client portfolios. The key differentiator of these models is that the advisor maintains control.
- Home-office models are constructed by a wealth manager’s in-house due-diligence and asset-allocation group. For distributors, the use of these models offers the dual benefits of increased control over investment selection and greater performance consistency across clients. When asked recently about portfolio construction, advisors indicated that they have warmed to the idea of using home office-developed model portfolios, as the percentage using models either exclusively or as the foundation of their portfolio construction process has increased from 39% in 2016 to 50% in 2020.
- Third-party model portfolios, including those from firms like Morningstar and Envestnet, have been widely adopted in the independent broker-dealer channel, as these advisors also seek efficiencies and centralized expertise. As the wirehouses strive to balance the goals of building a more centralized portfolio construction approach, while also providing their advisors sufficient choice, they are also adding third-party asset manager models to their platforms. In late 2019, Merrill Lynch added 40 model portfolios from four asset managers, which these asset managers created and will manage exclusively for Merrill.
The rapid growth of model portfolios represents both an opportunity and a risk to mutual funds. On the positive side, earning model placement is a more cost-effective and efficient way to gather assets compared to individual sales to financial advisors. Additionally, home-office and third-party models are controlled by “professional buyers,” who are generally members of a due-diligence group charged with applying objective measures to select investments that fulfill a specific role in the model. However, within the model universe, mutual funds face greater competition from other investment vehicles, including exchange-traded funds, separately managed accounts, and collective investment trusts, the latter in defined contribution plans, which can often provide similar investment exposures, but at a lower cost. Model-delivered SMAs, in particular, are a threat to active mutual funds in that they allow distributors to customize the portfolio and better control model pricing.
What This Means for Asset Managers
Appealing to the professional buyer community requires adhering to a more formal, stringent process of fund evaluation than encountered when interacting with the general financial advisor population. Understanding a fund’s role in the model is paramount, and measures of style and performance consistency will carry greater weight than absolute returns. Again, this calls for reorienting a sales strategy from an emphasis of many feet on the ground, to laser-focused, analytic engagement with the professional buyers.
For large asset managers that are selected to manage models on behalf of specific distributors, the asset accumulation potential is vast. That said, the economics for the manager are not the same as offering its own portfolios. For instance, in the case of the recently added Merrill Lynch model portfolios, the asset managers do not charge an overlay fee for managing the models, thus their success depends on the volume of assets they can attract into the models, about half of which flows to their proprietary products. This points toward a growing opportunity for smaller asset management firms to earn placement with models of their larger competitors. This is particularly true for those with strong track records in asset classes where active management can still outperform (e.g., emerging markets, small-cap equity), as well as those specializing in asset classes that help improve portfolio diversification, for which there are fewer options.
Another benefit of models is a more consistent, uniform push to improve portfolio diversification than was possible at the advisor level. The pursuit of less correlated asset classes is a key goal of model portfolios, but the optimal vehicle to provide this type of exposure continues to elude both distributors and asset managers. Interval funds, a type of unlisted closed-end fund that is offered continuously and can be redeemed on a periodic basis (typically quarterly), has seen a modest surge in assets in recent years. However, while distributors like interval funds for their ability to make less liquid assets available to retail investors, most think the lack of daily liquidity and current expense ratios make them too challenging and cost-prohibitive to use in models. That said, distributors have implied that they would be very interested in using these vehicles, or something similar, if asset managers were able to solve the operational and cost challenges interval funds currently pose.
With regard to model-delivered SMAs, while distributors are interested in them if they provide a cost advantage, asset managers must consider a number of factors before embarking down this road, most notably:
- Capacity constraints: Asset managers only have so much portfolio capacity, and they must decide how to allocate it across vehicles. For a popular strategy, model-delivered SMAs may not be the most profitable way to build assets.
- To clone or not to clone: Asset managers can either create SMAs that are exact replicas of mutual funds or introduce new strategies that may be more flexible than the mutual fund structure allows. Both scenarios hold implications for salability and management costs.
Why This Is Important for Fund Boards
The transition to models not only changes the buyer (from advisors to professional buyers), but also how a fund will be judged. Heavily weighted will be the consistency and reliability of performance under changing market and economic conditions, the sources of outperformance/underperformance, and the application of risk management processes. Oversight of individual funds will increasingly emphasize comparison to peers with tighter strategy alignment as opposed to broad category comparisons.
Home-office models significantly broaden the playing field of investment vehicles competing with mutual funds, many of which are lower cost. In assessing the viability of new and existing mutual funds, the potential for model placement must be a significant consideration, and the relative benefits of competing structures must be factored into any decisions.
Growing use of third-party models from asset managers is an opportunity for the industry, but firms must assess how they are positioned to compete for assets. For instance, does the firm have sufficient product bandwidth and modeling expertise to offer its own models? Or, does it have strategies that can complement the models of other managers by improving diversification, reducing risk, or adding alpha?
Earning placement within the models of large distributors often means making some difficult choices. Model-delivered SMAs offer substantial asset-gathering potential, but leadership must determine whether this route makes sense for them from both a capacity and cost perspective. This is particularly significant as these competing vehicles will leverage much of the analysis and portfolio management structure built for the mutual funds, whose interests, on behalf of the shareholders, lie with independent fund directors.
Robert Kennedy is a relationship manager for FUSE Research Network, which provides data and consulting services to the investment management industry—including to mutual fund boards. He works closely with FUSE clients to ensure that they achieve their strategic and tactical objectives, and is also a contributor to the FUSE BenchMark series and other FUSE research.