Model portfolios are quickly becoming the go-to way for advisors and investors to build and manage their investments. And thanks to the advent and growth of exchange-traded funds (ETFs), building a model has never been easier. Advisors and investors can instantly gain diversification advantages and build an asset allocation that suits their needs.
The question is whether or not investors and advisors need to do anything with that allocation.
The current debate remains on whether or not a static or dynamic approach remains the best way for advisors and investors to craft a model portfolio. Should we go custom with our allocations and change that allocation as time/economic conditions change? Or should we stay the course?
Models Take Hold
When it comes to investing, asset allocation is everything. The Modern Portfolio Theory tells us that building a portfolio of diversified asset classes and investments leads to better outcomes. When one asset class zigs another will zag. This smooths out returns and provides more stability to a portfolio.
Model portfolios have risen from this idea. Here, investors can use a model to build this collection of asset classes following a framework developed by the underlying asset manager or financial advisor. And thanks to the rise of ETFs, building models has never been easier. ETFs offer low costs and the ability to own wide swaths of asset classes with one ticker. Moreover, they provide easy access to more exotic asset classes. It’s now easy to add a dose of senior loans or commodities to a portfolio with one click.
But what used to be a simple exercise has now become more complex. Advisors and asset managers are craving more from their models. The rise and use of custom and dynamic models are growing.
That’s the gist at least, according to Cerulli Associates’ June-July issue of its U.S. Monthly Product Trends report. The investment researcher found that a full 30% of assets in asset allocation model portfolios are in custom models across various RIAs and broker-dealers. Asset managers report a slightly higher figure of 34%. Third-party strategists have just 3% of their AUM in custom models, but that number is growing according to the report.
And growth is the name of the game. The Cerulli survey showed that 60% of respondents reported that custom models are a top-three initiative for the future.
The question is should it be? And just how much change should there be?
Dynamic, Custom & Static
The debate within the world of model portfolios is how much deviation from the standard should there be and whether or not that change can come after the allocation is set. It’s here that we enter the world of dynamic and static models and see how much customization there is.
Static model portfolios are what we think of when we look toward allocation. A classic balanced fund is a perfect example of this. Here, we have a portfolio of 60% stocks and 40% bonds. That allocation stays the same throughout the entire length of the investment lifecycle. Pundits will argue that this is the essence of allocation and forms the basis of Modern Portfolio Theory. The portfolio is allowed to act throughout full market cycles, with various asset classes performing and underperforming to smooth out returns.
Custom models take this a step further. Here, advisors and asset managers design an allocation suited to an individual investor’s goals and needs. An investor looking for more tax-advantaged income might use dividend stocks and municipal bonds in place of a broad stock and bond allocation. They might use various ESG metrics to screen for investments within the allocations or add riskier junk bonds to add additional returns to the bond side.
Dynamic models can be custom or static. Here, the allocations are constantly changing.
An example of a static dynamic model would be the traditional lifecycle fund. The glide path is static and only adjusted every few years to meet the need for more conservatism in a portfolio.
Dynamic custom models are where it gets a bit wild for investors. Allocation decisions are based on the underlying asset manager’s outlooks and responses to economic and market conditions. This could be quarterly, semi-annually, or even monthly, and it could mean selling stocks in poor economic environments and then overweighting Treasury inflation-protected securities in a high inflationary climate, changing and setting the allocation as the managers see fit.
Wins on Both Sides
So, which approach is right? Well, it comes down to a myriad of factors.
For static portfolios, the biggest risk is that assumptions and current expectations don’t always hold true over the long haul. Risk, volatility, and correlations evolve over time. A few decades ago, U.S. and international stocks were not correlated. Today is a different story. Bonds have shifted over time between negative and positive correlations with equities.
Studies have shown that this creates problems with drawdowns, returns, and overall volatility. This chart from Richmond Quantitative Advisors (RQA) shows the differences in drawdowns between a dynamic model vs. a static one. Data from BlackRock also underscores this assertion and the potential for higher returns from a shifting portfolio.
_Source: RQA
However, the Bogleheads and static fans shouldn’t claim defeat just yet. The key to both RQA and similar studies comes down to one major factor — and that’s manager skill.
The reason static asset allocation works is that it’s really hard to predict trends and act accordingly. Being able to accurately pick that gold prices will move higher or junk bonds will crash is a tough job. The bulk of active managers struggle in this regard. As such, betting on the entire market and owning everything provides plenty of benefits over the long run. Again, the asset allocation works its magic.
One doesn’t have to go with only one option. A better approach may be meeting somewhere in the middle: going static with a portion of dynamic assets. Holding broad stock and bond allocation through a core portfolio seems to work best for the bulk of portfolios. Investors and advisors building a model can use a dynamic and custom approach for a portfolio of assets, shifting pieces around to change risk profiles and respond to economic/market conditions. The combination should prove to be fruitful over the long haul. There’s plenty of evidence to suggest that this sort of portfolio provides the best benefits.
Either way, model portfolios are here to stay, and advisors continue to adapt/use them to design investment outcomes for their clients. Choosing the right way to manage and build it may not be a “this or that” kind of decision. All approaches may bear fruit for investors.
Bottom Line
The use of model portfolios is on the rise and continues to see widespread growth thanks to the proliferation of ETFs. The pressing question is whether to be dynamic or static in the approach. The answer may be a little of each. Both styles add benefits to a model and drive better outcomes for all.
