Should you be considering model portfolios?

John Porteous, head of distribution at Macquarie, discusses the benefits of model portfolios.

As firms start to prepare for RDR, the requirement for a consistent and robust investment process for clients sits squarely at the heart of the strategic financial planning and wealth management process for many financial planners.

The FSA’s recent thematic review of platform adoption has highlighted the way in which some model portfolios have historically been deployed across client segments without adequate regard for individual client circumstances. While this is clearly a concern, the model-based approach to portfolio construction remains a popular way to deliver risk-graded investment solutions in the intermediary market, and is thus still a valid topic for debate.

Model portfolios can mean different things to different financial planners. For the purpose of this article, models will be defined as a series of investment solutions that can be characterised by a consistent risk profile, asset allocation and in most cases fund selection.

Not surprisingly, financial planners approach the issue of portfolio construction from many different perspectives. While some practitioners point to their expertise in analysing and identifying funds that offer the prospect of superior returns over time, others may adopt a more passive investment criteria both in investment style and market tracking.

Investment approach

The application and design of model portfolios often depend on the skill sets, resources and objectives of the individual firm. Depending on these variables, planning firms may decide to outsource fund research, or even the asset allocation of model portfolios, to external third party specialists. A more recent trend has been the delegation of model portfolios to external discretionary fund managers who make tactical and strategic investment decisions based around an agreed investment model specific to the individual financial planner firm.

Irrespective of any investment approach employed, the importance of a disciplined client-centric attitude to portfolio construction (and review) cannot be overstated as a vital component to delivering scale and efficiency into any planning practice. By delivering a consistent and repeatable process supported by a credible investment philosophy a firm can reduce risk, increase efficiency and improve client outcomes. At the core of this thinking is the principle that improving practice efficiency helps monetise the value of planning firms.
There is no standard or industry norm for the application of models in the financial planning community. Certain firms will use these as a point of reference in building bespoke client portfolios, others will seek to adopt them to reduce the risk of outlying investment/legacy assets where such funds may not be covered by in-house research.

New model thinking

Many of the consultants and asset transformation specialists, who guide firms through the process of moving their practices towards “new model thinking” (essentially the process of helping planning practices evolve into planning businesses), champion the use of a clearly articulated and deliverable client proposition. This can often involve a turnkey process taking the client through a comprehensive financial review and analysis supplemented by a risk profiling tool. This in turn feeds into a model portfolio which is reviewed and/or rebalanced at predefined intervals.

In addition to delivering more consistent investment outcomes for clients, model portfolios offer planning firms a number of advantages. Firstly, management information is easier to collate and clients who have portfolios that are significantly different from the recommended asset allocation guidelines are easier to identify and engage. Secondly, and significantly, technology such as wrap accounts can support this way of working (together with any subsequent rebalancing) at the touch of a button.

This latter point has been a major factor in the increasing application of model portfolios. A number of “New Model” firms have built their operations around the flexibility and control that can be achieved through platform functionality. This has given a number of smaller planning firms a comparable investment and reporting platform which was previously the domain of the larger and highly capitalised wealth managers. Client reporting, trading and even online client access can be wrapped (if you pardon the pun) into the standard client proposition.

Some firms apply rules to their portfolios indicating the tolerances against the strategic long term asset allocation. Clients whose investments move outside these limits are flagged and can be dealt with accordingly. Clearly, rules must be set in a manner that provides sufficient flexibility so that clients do not move out of line too frequently as a result of narrow guidelines.

Equally, the rules need to be within limits that don’t allow portfolios to drift into different risk profiles without flagging a review of some type.

Whilst models can offer many benefits they are not in themselves a panacea (as the FSA recently pointed out). If they are used without exception this can infer that all client circumstances can be covered by a predefined series of “optimal” client portfolios. This of course is highly unlikely – especially in the post retirement market where income becomes a dominant factor

Taking this theme to the next level, some model portfolios have been further refined by planners to reflect the optimum tax structure. Whether tax optimised model portfolios are conceptually sustainable is a moot point given the potential inconsistencies in tax landscape for UK investors, however, they remain an interesting development.

Legacy assets

Another matter that can often go overlooked is the treatment of legacy assets in the planning process. This can have a material impact on how a portfolio (however apportioned) can impact the allocation of wealth for a particular individual. Given that legacy assets cannot always be migrated onto a platform (which would, where possible, be the preferred modus operandi for planners) as a result of tax, cost or even emotional value, the blending of these investments with the core investment strategy will be a critical challenge to the overall holistic planning process.

The harmony between technology and the ability to manage and control model portfolios will doubtless continue to be a major talking point going forward – although perhaps even more influential will be the way that rapidly growing firms absorb the efficiency benefits that this manner of portfolio construction can offer whilst delivering a client experience that focuses entirely on the individual client, providing better holistic advice and service.

John Porteous, head of distribution at Macquarie