Model portfolios remain a non-transparent part of asset-management

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Efi Pylarinou is the founder of Efi Pylarinou Advisory and a Fintech/Blockchain influencer – No.3 influencer in the finance sector by Refinitiv Global Social Media 2019.

Model portfolios in the investment world are nothing new. They have been around for a long time and have always been unregulated. No model portfolio provider is required to report any or all of its model portfolios allocations, performance, or costs. In my early days of investing, most investment houses had a few model portfolios to recommend for various investor goals. Some model portfolios had a tax efficiency focus, others an income focus, or a growth at low-cost focus etc. Diversification and cost efficiency were always the main advantages of choosing model portfolios.

Model portfolios were mainly built using mutual funds. Financial advisors had a choice of mutual funds for each asset class recommended by the model portfolio.

Fast forward to 2020.

Model portfolios are on the rise over the past two years and the large ETF issuers, offer a larger variety of model portfolios. Blackrock, the leader according to the latest Morningstar report, has the most model portfolios of them all – 51 in total!

The broad choice includes, passive, or active, or blended model portfolios and within each of these there are choices with an income focus, or to maximize after tax returns or focused on ESG, or thematic investing etc.

Screen Shot 2020-08-24 at 20.28.07

Since 2018, there are more than 400 new model portfolios in the market. The lack of transparency has not changed significantly, and it is not clear how much money goes into these model portfolios.

However, what has changed significantly is that a large part of model portfolios is constructed with ETFs rather than only mutual funds as in the old days.

Broadridge Financial Solutions, uses data analytics to gain insights into model portfolio trends. They report that by the end of Q1 2020, mutual-fund only model portfolios were 42% of all model portfolios. ETF-only model portfolios accounted for one third – c. 33% – of all model portfolios and the rest – c. 25% – were hybrid (ETFs and mutual funds).

The $3 trillion model portfolio market (estimated by end of Q1 2020) is increasingly concentrated and controlled by the large asset managers. The top ten asset managers control 64% of all assets in model portfolios (up from 62% in the previous quarter).

Three trillion are insignificant in the asset management industry but the trend is clear. The model portfolio market is much larger already, given the huge recovery in Q2 2020. Concentration will not stop because of the commission-free trading of ETFs and the continuous increase of low-cost investment solutions.

The model portfolio concentration may explain spikes in monthly ETF flows seen in certain ETFs (issued by the top asset managers – Blackrock, Vanguard, and Schwab etc).  Bloomberg has been reporting frequently lately on this topic and suggesting a link of certain large fund flows to model portfolio strategies.

In one of the Bloomberg graphs reported in `Wall Street creates 3 trillion whale in model portfolio boom` , it is clear that close to $1billion of assets shifted out of SCHX (Schwab Fundamental US large-cap index ETF) – and into FNDX (Schwab US large-cap index ETF) in just a few days in June. It smells like a model portfolio directed shift.

Reflections

Regulators don’t seem that concerned with the growth and concentration of model portfolios. The increasing share of ETF is another testament of solid popularity of wrapper used by all robo-advisors. Wealthfront, the digital investing early pioneer, has its own menu of model portfolios (see some samples below) and uses a short list of ETFs.

Source: Wealthfront

The biggest risk in model portfolios is that often their labeling is misleading and or proves to be misleading. Traditionally, model portfolios included `Balanced`, `Conservative`, `Growth` and other similar names, in their nametags; and still do. Nowadays, we see also ESG`, ` Innovation`.  Since reporting is not mandatory, most asset managers can cherry-pick which portfolio they choose to share with Morningstar and also show their performance in a largely delayed fashion (even 1 year later).

Last year the Vanguard ESG U.S. Stock ETF (ESGV) had incorrectly included 11 stocks due to an ESG screening error by the index provider FTSE Russell. At the time (Aug 19, 2019) ESGV had $558.5 million AUM an has of Aug. 21, 2020, ESGV has $1.77 Billion (more than triple).

This is an example, of an error in an ETF (which would spill over into model portfolios) that was corrected. There seems to be a wider concern of ESG mislabeling as ESG ratings are not objective and often combine diverse metrics into one rating score (e.g. environmental and governance metrics).

SEC commissioner calls for better ESG labelling via @financialtimes July 21, 2020

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