Identifying clients who have the most to gain with model portfolios
Financial professionals are typically highly informed about their clients; specifically, what their investment objectives and time horizons are, as well as their investment return expectations. This puts financial professionals in a strong position to conduct client segmentation that forms the initial important step in the process of incorporating models into a practice. Through the process of client segmentation, you’re looking to identify specific areas within your practice where model portfolios may be able to add value.
Criteria on which to segment a client base
Client segmentation can involve multiple permutations, but there’s merit in keeping it simple and holistic at the outset. The objective is to be able to identify at a high level the pockets within a practice where either a group of clients can gain value from models or where models can be a benefit to the practice through increased efficiencies.
An illustrative example of holistic client segmentation
Four primary criteria—divided by qualified and nonqualified accounts—provide a high-level overview of client needs and circumstances: tax liability, assets, revenue, and complexity.
- Qualified versus nonqualified
As clients in qualified accounts aren’t liable for taxes when changing underlying investment components, a move into model portfolios can be accomplished more seamlessly. Clients in nonqualified accounts can be further segmented by low or high unrealized gains, with the former also potentially able to benefit from a move into model portfolios without significant tax consequences. Clients with high unrealized gains may benefit from model portfolios, too, but a more thorough analysis may be required before a final decision is made.
- Assets and revenue
Monitoring clients’ investment portfolios and reporting on holdings, investment changes, and performance remain a valuable and critical part of the advisor/client relationship. Using model portfolios can help you gain greater efficiencies by serving the investment needs of clients with expert and professional institutional investment skills. Meanwhile, you can continue providing a high-touch approach to those clients with sizable assets under management and who contribute significantly to total revenue.
Some clients have more sophisticated or complex needs than others where—in addition to their standard investment or retirement portfolio—they may be active private markets or alternatives investors or have an accompanying stock trading account. Segmenting clients by level of sophistication or complexity allows you to further analyze the specific needs of these clients before determining if a model portfolio can add value.
Through relatively simple segmentation, you can identify unifying characteristics—whether it be taxation, an opportunity for increased efficiencies, or level of client complexity—that may point to where model portfolios may add the most value within your practice. In this way, incorporating models becomes a hybrid approach initially, where models are used to complement an existing investment proposition.
The next step involves choosing the specific type of model that best suits clients’ needs. One model may help to solve multiple objectives; for example, clients nearing retirement age may be looking to generate income. Meanwhile, clients with a conservative investment mandate may not require income but may be searching for both capital growth and lower-risk returns. A multi-asset income model may be the appropriate choice in both these scenarios.
Case study 1: using a multi-asset income model portfolio for both retirement and conservative investors
In this case study, a financial professional has concluded client segmentation and identified a multi-asset income model as being well suited to retirement clients needing an income, as well as preretirement clients with a conservative risk profile.
To communicate the value that the portfolio may offer, the financial professional compiles an outline of the current investment environment and the challenges that the portfolio could help solve.
Current investment landscape—the challenge for income generation
- Since 2007, the yield on a 50/50 stock and bond portfolio has fallen by 70%.
- To generate a 3% to 4% yearly income from a portfolio that returns 1.32% will result in an erosion or drawdown in principal.
- As income is based on a percentage of principal, it declines over time as the principal depletes.
Historical yield of a 50/50 stock and bond portfolio (%)
Source: Morningstar, as of December 2021. For illustrative purposes only. The equity allocation is represented by the S&P 500 Index, which tracks the performance of 500 of the largest publicly traded companies in the United States. The fixed-income allocation is represented by the Bloomberg U.S. Aggregate Bond Index, which tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets. It is not possible to invest in an index. Past performance does not guarantee future results.
Outsourcing to a third-party model manager—a potential solution for generating higher income
- To generate higher returns when traditional income assets are at historically low rates requires access to higher-income sources.
- However, risk management and mitigation remain high priorities and require careful attention.
- Nontraditional income sources, such as emerging-market debt, U.S. REITs, and high-yield corporate debt may help to enhance returns but also carry a higher level of investment risk.
Current yield versus 5-year maximum drawdown (%)
Source: Morningstar Direct, as of December 2021. For illustrative purposes only.
Outsourcing to a third-party model manager specializing in income portfolios can help provide access to higher-income sources within a risk-managed framework. Large institutional model portfolio managers have investment and research teams that span the globe and are able to combine expert investment analysis with on-the-ground insight to identify investment opportunities across a broad spectrum of asset classes. Choosing the right model portfolio provider is an important decision.
Case study 2: incorporating a tax-sensitive model portfolio for tax-aware clients
In this case study, a financial professional has identified multiple clients who require a more tax-efficient investment approach through the use of passive investment components. However, the financial professional doesn’t want to entirely exclude active management and decides to use a model portfolio that can combine both approaches.
- Increasing the use of exchange-traded funds (ETFs) may increase tax efficiency within an investment portfolio.
- Tax-sensitive strategies seek to reduce taxable income and, therefore, tax liabilities.
- However, for high-conviction positions, active management may be more rewarding.
Achieving tax efficiency through outsourcing
Outsourcing to a third-party model manager specializing in tax-aware portfolios can help increase the tax efficiency of the equity portion of a portfolio by incorporating ETFs.
- Additionally, a model portfolio can incorporate strategic beta strategies that seek to outperform market-capitalization-weighted benchmarks.
- In a multistyle investment approach, mutual funds can be incorporated to provide exposure to investment-grade and high-yield bonds, while ETFs can help increase diversification and reduce interest-rate sensitivity within a portfolio.
Asset allocation breakdown of a tax-aware model portfolio
Source: John Hancock Investment Management, February 2022. For illustrative purposes only. Not indicative of any fund.
A customized approach to incorporating models into an advisory practice
Model portfolios can provide numerous benefits to your clients as either a stand-alone solution or as a component of a wider investment portfolio, and incorporating models into an advisory practice doesn’t need to be a time-consuming process. Relatively simple but effective segmentation helps you identify those clients for which model portfolios can help to add real value.
Although there are common myths about model portfolios, one study has found that 87% of financial professionals report expectations having been met or exceeded through outsourcing, and the more financial professionals outsourced to a model portfolio provider, the greater their total assets and the lower their operating costs. Exploring the use of model portfolios within a wider investment proposition is one investor-focused approach to building a sustainable and effective advisory business for the long term.
For the 50/50 portfolio, the equity allocation is represented by the S&P 500 Index, which tracks the performance of 500 of the largest publicly traded companies in the United States. The fixed-income allocation is represented by the Bloomberg U.S. Aggregate Bond Index, which tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets. Intermediate U.S. Treasury bonds are represented by the Intercontinental Exchange (ICE) U.S. Treasury 7–10 Year Bond Index, which seeks to measure the performance of outstanding U.S. Treasury bills with a minimum term to maturity greater than 7 years and less than or equal to 10 years. Bloomberg U.S. Agg Bond is represented by the Bloomberg U.S. Aggregate (Agg) Bond Index, which tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets. High-yield corporate bonds (corp) are represented by the Markit iBoxx USD Liquid High Yield Index, which comprises U.S. dollar (USD) high-yield bonds selected to represent a balance of the USD high-yield corporate bond universe. International high-yield equity is represented by the S&P International Dividend Opportunities Index, which tracks 100 high-yielding common stocks from around the world, excluding the United States. National muni bonds are represented by the S&P National AMT-Free Muni Index, which tracks the performance of the investment-grade tax-exempt U.S. municipal bond market, excluding the U.S. territories. Investment-grade corporate bonds (corp) are represented by the Markit iBoxx USD Liquid Investment Grade (IG) Index, which tracks the performance of U.S. dollar (USD) denominated IG corporate debt. U.S. real estate investment trusts (REITs) are represented by the Dow Jones (DJ) U.S. Real Estate Index, which tracks the performance of REITs and other companies that invest directly or indirectly in real estate. U.S. high-yield equity is represented by the Morningstar Dividend Yield Focus Index, which tracks high-yielding, dividend-paying, U.S.-backed securities screened for superior company quality and financial health. It is not possible to invest directly in an index. Diversification or asset allocation does not guarantee a profit or protect against a loss in any market. Past performance does not guarantee future results.