Model portfolios are a predetermined combination of funds designed to meet the needs of a broad group of investors.
Some providers define models in terms of risk/return metrics, however objective- driven models are distinctive because they take a goals-based approach. This means there is a direct link back to the client’s desired investment outcomes, rather than a focus on traditional risk/return classifications.
Clients don’t identify as easily with investment objectives – which are often defined using prescriptive, sometimes abstract quantitative metrics – as much as they do with their own investor goals. Model portfolios are structured solutions that directly connect investor goals with investment objectives. For example, they might be looking to build a pool of assets to draw on in the future, or they may be looking to receive a regular income, or to preserve the wealth they have already accumulated.
From the outset, model portfolios should be designed to meet these client- driven, long-term goals. Once the client goals are established, these targeted strategies select a combination of funds – each with a specific purpose – to help deliver outcomes aligned with these goals.
Importantly, objective-driven solutions should be:
- Easily understood and implemented
- Cost effective
What should the characteristics of objective-driven models be?
How are models built?
Objective-driven models emphasise investment objectives that align with client goals in order to drive investment decisions. Investment objectives such as growth of capital, or current income, or preservation of principal serve to distil specific client needs when building wealth (i.e. accumulation stage), spending wealth (i.e. distribution stage) or conserving wealth.
Objective-driven models tend to move away from the traditional investment framework. Traditional investment strategies are typically based on a specific investment universe, and tend to focus on specific asset classes or investment styles. In contrast, objective-based strategies are defined by their investment strategy, which tends to be aligned with client goals. Traditional strategies thus focus on where to invest, while objective-based approaches specify how to invest, leading to greater flexibility away from the traditional constraints of size, style and domicile.
Traditional investment approaches are appropriate for delivering and measuring pure investment outcomes, but these do not always correspond to the client objective.
An example of how this could work in practice might involve a client who wants a balance between building, spending and conserving wealth. To achieve this goal, a model that uses a balanced income strategy might be most appropriate. Not only would the model portfolio be adjusted to vary the amount of equities to match the client’s risk tolerance, but it would also use investment objectives to vary the type of equities needed to deliver on their ultimate goal. In this case, funds with more defensive equities, like those found in the ‘growth and income’ and ‘balanced’ categories, would be selected to provide some capital preservation/downside protection. Using this approach, asset allocation is a result of bottom-up selection of the underlying funds, rather than a top-down decision. Asset allocation thus becomes the output of the investment solution rather than the input.
Illustrative portfolio with multiple objectives – growth and income
How do objective-driven model portfolios help to deliver client goals?
Explicitly target client outcomes
By clearly targeting, from the outset, results that are aligned with the client’s real- life investment goals, objective-driven model portfolios are more likely to deliver outcomes that are consistent with those goals. Models move beyond a narrow focus on just risk tolerance, to understand that clients have different time horizons and cash flow needs. For example, a shorter time horizon suggests added emphasis on downside protection and greater use of income-oriented strategies. Using a different lens to construct objective-driven portfolios shifts the focus from ‘where’ a portfolio is invested, to ‘how’ it is invested, as outlined above.
In order to meet the ultimate client goal, rigorous analysis is undertaken to identify how each underlying fund will work together to meet the specific investor outcome. To do this, detailed knowledge of each fund’s return drivers, portfolio characteristics, volatility, downside protection and inter-correlation is needed.
Forward-looking analytical tools and quantitative, systematic assembly
A focus on modelling future scenarios places greater emphasis on how a solution will deliver against the client’s ultimate goal. Forecasting tools and analysis help paint a clearer picture of how the underlying funds will respond in a range of economic environments over different time horizons.
Single asset management house
The level of analysis needed to construct objective-driven portfolios underscores the advantage of a single-asset-manager model. In-house, proprietary knowledge of an individual fund level can provide comprehensive insight into how each fund will behave and respond under different market scenarios.
This means a greater level of transparency and detail when evaluating portfolio positioning and results. For this reason, we believe that objective-driven models can be more effective if they are managed, controlled and determined by a single provider.
Why are wealth managers and others increasingly using objective- driven model portfolios?
Tighter regulatory requirements
Stricter regulations designed to protect client interests are driving industry participants to look for disciplined, consistent solutions.
While specific regulatory changes will vary by region or country, there is a general shift towards greater consumer protection. For example, a fundamental element of the regulatory changes in Europe introduced through MiFID II in January 2018 was to enhance protection for both professional and retail investors. In particular, it requires investment firms to assess and report on the ‘suitability’ and ‘appropriateness’ of the investment solutions they are providing to their clients. Objective-driven model portfolios can help wealth managers provide suitable solutions across a broad client base in a consistent manner.
Complexity of investment landscape can result in wide variation of returns
As the investment landscape has become more complex, there are a greater number of investment options available to address a broad range of client needs. This means it can be increasingly difficult to ensure consistency in the investment solutions offered to clients, with similar objectives and risk tolerances, within the same firm.
Targeted solutions can provide consistency for firms
A range of well-defined, objective-driven portfolios that cater to a clear set of investor needs can help wealth mangers provide efficient, effective investment solutions to their clients.
Objective-driven models are well-suited to this new regulatory environment. Because client outcomes are at the heart of each strategy, a consideration of their suitability and appropriateness are ‘baked in’ to each solution.
Greater client focus translates to gains for wealth managers
By using objective-driven model portfolios to deliver clients’ desired investment goals, advisers are able to concentrate on their core competencies – namely, the client relationship aspects of their business, client servicing and retention, and growing the practice.
In this respect, model providers do not compete with wealth managers, but instead work in tandem, as both are engaged in their area of expertise, to achieve the most rewarding outcome for the client.
Moreover, evidence from a US-based study suggests that investment practices that are more focused on client relationships, rather than investment management, could build a larger, more profitable client base, with an associated increase in revenue. (1)
By targeting results that are aligned with the client’s real-life investment goals, objective-driven model portfolios move beyond a narrow focus on just risk tolerance to understand that clients have different time horizons and cash flow needs.
(1) Source: Cerulli report on portfolio construction, SEI and FP Transitions US-based study of 8,000 advisors, published 2016
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