The Rise of Model Portfolios for Advisors

Model portfolios are continuing to gain traction across the industry. With their rise in popularity, the current marketplace is flooded with options. So how can advisors sort through the wide range of choices?

When you have a strong framework and understanding for evaluating these strategies, it’s easier to deliver better results to clients. Our Morningstar researchers dive deeper into the broader model portfolio industry and provide considerations for evaluating target-risk portfolios.

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In our study, a model portfolio is defined as an investment blueprint offered by asset managers for advisors to follow. Advisors can implement models in different ways, such as following versions posted on providers' websites or using third-party platforms to handle execution.

While model portfolios can focus on a single asset class, most exist within a series of multiple portfolios designed for a variety of risk tolerances. To help investors sort through thousands of portfolios, we offer the Morningstar Medalist Rating—a forward-looking assessment based on assessments of a strategy's investment merits. The ratings can either be quantitatively derived or assigned by a Manager Research analyst.

Here's a closer look at the model portfolio landscape.

As of December 2023, asset-allocation model portfolios falling in the allocation global broad Morningstar category accounted for more than 77% of all models reported. In fact, there are 6.5 and 9 times more allocation models than equity and fixed-income models, respectively, in absolute numbers.

These asset-allocation models generally come in a series format, delivering a variety of portfolios across different stock/bond mixes for different investor risk profiles. Some series even include more than 10 mixes.

Low costs are a strong selling point for model portfolios. Our study reveals that model portfolios have a large fee advantage versus mutual funds within each target-risk allocation category.

And they’ve remained cheaper over time. The graph below shows fees back to December 2020, where allocation models were almost 19 basis points cheaper than the cheapest allocation mutual funds. Prices keep moving downward to the investors' benefit and have kept their lead on mutual funds.

Due to the rapid growth of off-the-shelf model portfolios, it has become hard for providers to differentiate themselves. Morningstar researchers find that model providers indicated implementing tax efficiency or tax optimization into their models' lineup as the largest growth opportunity. At the portfolio level, this can include introducing tax-efficient underlying ETFs or swapping out taxable-bond funds for municipal-bond funds.

Using different vehicles than traditional mutual funds and ETFs as underlying model portfolio holdings is the next biggest trend. Custom models are also a key focus area and as they gather momentum, Morningstar plans to further explore the differences between a firms' custom and off-the- shelf offerings. 

The proliferation of target-risk model portfolios—multi-asset strategies designed to fit an individual's risk tolerance and preference and serve as their portfolio core—and their narrow range of returns can create a paradox of choice for advisors. Below are some best practices for the fundamental pillars Morningstar uses to evaluate target-risk portfolios.

The investment team and its supporting resources are the focus of the People Pillar.

• Allocation teams should have a range of relevant backgrounds related to portfolio construction, equities, fixed income, and other asset classes, like alternatives.

• Bigger teams aren't necessarily better, and smaller ones aren't automatically disadvantaged. For example, more complex models may benefit from larger teams while simple models may be able to succeed with smaller teams.

The best processes are clearly defined and repeatable. Understanding how a team sets the model’s strategic asset allocation and manages risk are good to consider.

• Target-risk models’ primary objective is to balance returns and risk. So, it's important to make sure they have proper risk management guardrails to ensure they deliver what clients expect.

• A team shouldn’t favor its own firms’ unproven funds over more established outside options.

A good Parent puts investors' interests first. They are for-profit enterprises, but ones that succeed by prioritizing stewardship over salesmanship.

• Better Parent firms attract, develop, and retain investment talent. They also have clear and thoughtful team structures and succession plans.

• They don’t chase investment fads or trends. Instead, their models and underlying funds are based on time-tested and repeatable investment strategies and asset-allocation plans.

Models tend to be cheaper than equivalent mutual funds, but it's still important to pay attention to fees. In addition to the asset-weighted fees of the underlying investments, some firms may charge additional fees, commonly referred to as a strategist fee.

Now more than ever, advisors need to understand the possible benefits of model portfolios. When you know how to evaluate their different options, you can start meaningful conversations and help clients reach their financial goals.

Deliver quality advice with Morningstar Direct. Our platform gives you the tools you need to curate a library of model portfolios, custom benchmarks, and accounts. From there, you can connect that library to modules across Direct for even deeper insights.

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