Convenience From Model Portfolios Brings Risk

In this increasingly automated world, more and more financial advisors are getting their clients into automated portfolios.

Known as model portfolios or robo-investing, these investment platforms are set-it-and-forget-it cookie-cutter affairs, and the cookie portfolios they offer come in several different varieties, depending on the individual client’s tolerance for risk. In exchange for these portfolios’ simplicity, investors give up control, as customized portfolio management isn’t involved.

Despite various downsides, the use of these portfolios is growing apace, as demand for them is prompting advisors to offer them to grow their businesses. A recent survey of 500 advisors by Broadridge Financial Solutions showed that 85 percent of them are using model portfolios and that more than half of the assets they manage are in these vehicles.

These portfolios, which allocate clients’ money to an array of index funds according to set formulas, are generally viewed as a way to control fees, as they tend to involve less trading. But, in addition to the fee of the advisor who sells you a model portfolio, you also must pay the fees charged by the various funds to which the portfolio allocates your money. If you’re paying the advisor annually one percent of your total assets in a model portfolio and each fund is charging you .5 percent, your total annual fees are 1.5 percent.

One reason for market volatility is computerized trading, in which big institutions use programs that respond to certain events by automatically selling or buying huge volumes of shares. For example, when the S&P 500 falls below its 200 moving-day average, many algorithms may start selling rapidly, creating high downside volatility. If you’re in a model portfolio, this can create serious risk-management concerns.

Model portfolios can be useful for younger investors and others typically without substantial assets, as many of them may not need the customization that human asset management can provide. But affluent investors like medical and dental professionals do, as they tend to be seeking to beat the market through skilled portfolio management. Moreover, such clients need the risk management that can come from the flexibility of advisors to under-weight or over-weight certain sectors versus the market, i.e., the S&P 500.

Among the downsides of model portfolios:

• Total costs are often higher than they appear at the outset. “The stated fees typically start low, but usually don’t include fund-level fees [those charged by the various index funds that model portfolios use], as well as the potential for add-on fees,” says Kipp Goll, a partner at Autus Asset Management in Scottsdale, Ariz.
• In some cases, a loss of control for tax-management purposes. Tax situations can be different for different investors; the design of model portfolios sometimes doesn’t take this into account. This is crucial because selling assets often has tax consequences.
• Because of their tendency to favor rising sectors, these automated portfolios often function in ways akin to market-timing and thus increase investor’s risk. Some model portfolios set the stage for potential loss by indirectly over-exposing you to certain sectors that have run up over time.

For example, before the tech crash of March 2,000, which triggered a deep market correction, a river of new money had been flowing into rising tech growth stocks. Investors who had purchased an S&P 500 index fund (a large portion of which had been the tech sector) became greatly over-exposed, and when the sector fell, they got hammered. Based on their methodology, investors in some model portfolios would have been caught up in this if this investing method had existed at the time.

Another example of an abrupt market shift occurred in 2014-2016. The price of oil dropped from a peak of $115 per barrel in June 2014 to under $35 at the end of February 2016. As energy stocks had been rising steeply, many investors had clamored into S&P 500 index funds, only to get clobbered as the price dropped precipitously because those funds had become over-exposed to the energy sector. Among these investors were those whose money had been invested in energy funds automatically by model portfolios, which had been introduced several years earlier.

Market risks stemming from the growing popularity of passive investment vehicles (such as index funds and ETFs) can’t be avoided completely by sticking with actively managed portfolios. Passive stock funds have grown to hold more than $3 trillion in less than 10 years, according to Morningstar. This is causing a risk bubble from the potential for popular stocks to get hammered if investors in these funds suddenly liquidate.

Because of this risk, it’s critical for active stock investors to ensure that their advisors are taking these risks into account, managing their stock portfolios tactically and nimbly, and maintaining portfolios with substantial diversification to minimize damage in the event of heavy fund withdrawals from stocks they own when this passive-fund investing bubble pops.

The Broadridge study’s findings suggested that, beyond investment management expertise, advisors see a need to make financial planning and client service a priority. Model portfolios are often used by advisors who use them to free up time to look after other areas for clients. By leaving asset management to the model programs, they have more time to help clients with tax management, estate planning, cash flow management, and other services. By using a model portfolio then, hopefully, your advisor will have more time to provide these other services.

There are many ways that advisors can use technology to make their practices more efficient but serving clients--not convenience for the advisor—should be the focus. What affluent clients still need—and will always need—is the customization that comes with the human factor: a human advisor who understands their needs, situations, goals, and fears as unique human beings, and apply that too customized portfolios.

David Robinson, a Certified Financial Planner, is founder/CEO of RTS Private Wealth Management, an SEC-registered firm in Phoenix that provides fiduciary services to help clients achieve their financial goals. His practice focuses on helping wealthy individuals with custom financial plans, using a holistic approach to grow/protect wealth, manage taxes, identify insurance solutions, prepare for retirement and manage estate plans.