Model Portfolios for Investment Management: The Key to Efficiency?

Duane McDonald, ChFC®, AIF®, RICP®
Duane McDonald, ChFC®, AIF®, RICP®

08.22.18 in The Fee-Only Advisor

Estimated Reading Time: 6 Minutes (1126 words)

Fee Only Advisor

To grow a successful fee-based practice, efficiency is key. But the more new assets you convert to fees, the more time consuming it becomes to invest and manage them. Many advisors solve for the time dilemma by outsourcing investment management, but many others 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 options for managing assets yourself, with a focus on using model portfolios for investment management.

Know Your Options

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

Custom allocation of investments. 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.

The custom option entails a huge time commitment, and little scalability or efficiency can be gained for the investment management process.

Standardized allocations. Here, you 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 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 like something that could work for you? Let's discuss where to begin!

Build Your Model Portfolios

You don't need to 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

  • Reduce the number of investments you track

  • Spend more time with clients and prospects

As you screen funds for possible inclusion in your models, pay close attention to each fund's investment history and merits. 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, expense ratios, and fund minimums.

Back-Test Your Models

Once you have 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 Workstation. Here's how you do it:

  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 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, our advisors can monitor portfolio drift and place trades in seconds to rebalance accounts and bring them back in line with the model.

Develop Rebalancing Procedures

Rebalancing is a key component of any 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. As such, 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

When should you rebalance? Most advisors prefer calendar rebalancing—quarterly, semiannually, or annually. Annual rebalancing is the most common, but you can 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.

What is your rebalancing threshold? 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 strategy you choose, documenting your processes will help you apply your rebalancing strategy consistently across accounts.

More Time to Grow Your Business

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

Editor's Note: This post was originally published in September 2015, but we've updated it to bring you more relevant and timely information.

This material is for educational purposes only and is not intended to provide specific advice.

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