Building block model portfolios introduce greater flexibility

“Building block model portfolios are a new way for financial professionals to leverage the expertise of a professional investment team.” Steve Deroian

The model portfolio industry is growing and expected to reach $10 trillion by 2025,¹ and as is often the case, growing industries spur innovation. Building block model portfolios represent an innovative evolution within the model portfolio industry where financial professionals can access asset class-focused model portfolios with professional management and diversification as standard. Here are three ways that building block model portfolios may benefit an advisory practice.

1    Easier access, flexible execution

For financial professionals who’ve hesitated adopting model portfolios for various reasons, building block model portfolios introduce a new level of flexibility. By providing diversified asset class-specific exposure, these building blocks can complement a broader investment portfolio while being easy to adopt and implement.

In our review of how to incorporate a model portfolio into an advisory practice, we suggest a starting point of segmenting clients to identify those who can be easily transitioned to a model portfolio approach. These are typically clients in qualified retirement accounts with relatively uncomplicated investment needs and lower investable assets. With building block model portfolios, financial professionals can more seamlessly incorporate exposure to sleeves of asset classes—from fixed income to U.S. or international equity—into broader investment propositions. Clients benefit from professional asset allocation and investment expertise, while for an advisory practice, it may translate into cost-efficiency and time savings. Financial professionals can allocate more resources to holistic financial planning and client relationships, as a result. 

What is the low-hanging fruit when considering model portfolios?

Clients most suited to an immediate move into model portfolios

2    Maintaining control over an asset class 

Financial professionals can choose building block model portfolios for different reasons, such as to maintain their own opinion on an investment view or adding expertise to supplement resources.

Where a financial professional has expertise or experience in manager selection, they may want to maintain a hands-on approach to that asset class while leveraging model portfolios to help minimize the work in asset classes where they may feel less technically proficient or where they lack required resources. For example, an advisor may choose to use a building block model to access international stocks and fixed income but continue selecting U.S. equity strategies based on their years of experience and research in that asset class.

Model portfolio providers differ in what they offer, and financial professionals should aim to partner with a provider that, by default, incorporates all of the following into portfolio construction:

• Asset or sector allocation views—using robust research to model optimum weightings across sectors
• Diversification—across international and domestic markets and sectors
• Investment-style flexibility—using either active or passive investment styles, or a combination, based on the most optimal approach for specific investment opportunities

Asset class exposure with building block model portfolios

Example of a fixed-income model portfolio with broad sector diversification

^{Source: John Hancock Investment Management, January 2023. For illustrative purposes only and not reflective of any fund. Diversification does not guarantee a profit or eliminate the risk of a loss.}

One benefit of building block model portfolios is diversification across sectors, which may result in better risk-adjusted returns for investors when compared with following a standardized index.

For example, comparing the potential returns of a diversified fixed-income model portfolio to using a fixed-income index, such as the Bloomberg U.S. Aggregate Bond Index, the model portfolio provides higher returns and, importantly, higher risk-adjusted returns with a Sharpe ratio of 0.59 compared to 0.51 for the index.

Comparing the risk/return of a diversified fixed-income model portfolio

1/08–12/22

^{Source: Morningstar, John Hancock Investment Management, January 2023. Corporate bonds are represented by the Bloomberg U.S. Corporate Bond Index, which tracks the investment grade, fixed-rate, taxable corporate bond market. Mortgage-backed securities are represented by the Bloomberg U.S. Mortgage-Backed Securities Index, which tracks 15- and 30-year fixed-rate securities backed by the mortgage pools of Ginnie Mae, Freddie Mac, and Fannie Mae. Treasury bonds are represented by the ICE U.S. Treasury Core Bond Index, which is a market-value-weighted index designed to assess U.S. dollar-denominated fixed-rate securities with a maturity of between more than 1 year and less than or equal to 30 years. High-yield bonds are represented by ICE BofA U.S. High Yield Index, which tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market and includes issues with a credit rating of BBB or below. Emerging-market debt is represented by the J.P. Morgan EMBI Global Index, which is a market-capitalization-weighted index that tracks the performance of U.S. dollar-denominated Brady bonds, Eurobonds, and traded loans issued by sovereign and quasisovereign entities. It is not possible to invest directly in an index. Past performance does not guarantee future results.}

3    Professional manager research

The merits of an active versus passive approach in investing differs between sectors and can also differ at varying points within a market cycle. For example, within fixed income, an active management approach in areas such as high-yield bonds or emerging-market debt may be more suited to finding compelling investment opportunities at different stages of the credit cycle. Whereas a passive approach in equities, for example, may be better at capturing return potential in that asset class. Depending on the model portfolio provider chosen, financial professionals can benefit from professional manager research and investment style analysis across asset classes.

How does professional manager research help narrow the search for managers within an asset class?

There are around 637 active high-yield bond and 257 emerging-market debt funds listed on Morningstar, which represents a major challenge for any financial professional trying to conduct manager due diligence. A model portfolio undertakes this onerous but important analysis, and ongoing monitoring, as part of the portfolio construction process, saving both time and resources for advisory firms.

Manager universe—high-yield bond and emerging-market debt managers

^{Source: Morningstar, John Hancock Investment Management, January 2023.}

Bringing together the benefits of ease and flexibility

Building block model portfolios are emerging as an innovative evolution in the model portfolio industry, offering a potential win-win for financial professionals and their clients. Backed by the same level of asset allocation expertise, research, analysis, and manager search and selection as asset allocation model portfolios, building block model portfolios help to bolster a financial professional’s capabilities and represent an easy and flexible way to save time and resources within a practice that can be dedicated to clients’ broader financial planning needs.