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Advisor Insights

Of Models and Management

Advisors outsource investment management to focus on financial planning.

There is an old joke that defines economists: They spend their days looking at reality and wondering if it would work as a model. While it is undoubtedly a little harsh, it highlights both the complexity of the economy and the desire to standardize.

It is, therefore, unsurprising that outsourcing investment management has become so popular among advisors, especially in developed markets such as the United States and the United Kingdom. Faced with the joint complexity of financial markets and the individual situation of each client, it is natural to seek a rules-based approach that reduces the number of decisions required to build a portfolio.

Evidence of this popularity is provided by a recent report by the consultancy Lang Cat.[1] It showed that 84% of U.K. advisors now operate a “centralised investment proposition” or standardized investment solution, covering 80% of the assets they are investing on behalf of clients. Of these advisors, 62% use some form of outsourced investment management.

This includes both model portfolios supplied by investment consultants but implemented by the advisors themselves, and managed portfolios, which are implemented on a discretionary basis by an asset manager. Both approaches are popular and share several common characteristics, but they are best-suited for different advisor business models.

The Evolution of Outsourcing
The future of these strategies, therefore, depends upon the evolution of the advice model. To understand how investment propositions may evolve, we must first understand how we reached our present state.

The advisor community has transformed over the past 25 years, especially here in the United Kingdom. From the advent of compulsory qualifications in the mid-1990s through to the regulatory overhaul of the Retail Distribution Review a few years ago, advisors have faced numerous challenges to their business model. Like any evolutionary system, each challenge was overcome by those able to adapt to the new environment.

One of the most notable changes was the decline in the use of insurance company products in favor of portfolios of mutual funds. This corresponded with advisors increasingly defining their service as investment advice.

After the global financial crisis of 2008, though, many advisors saw a need for additional help in building portfolios that more closely aligned to the risk profile of their clients. This help was often found in model portfolios supplied by investment consultants and implemented by advisors.

Pros and Cons of Model Portfolios
Model portfolios are widely used today, though there are drawbacks. An enduring advantage of model portfolios is that the advisor remains in control of the investment proposition and client experience. In many cases, clients are unaware that the model portfolios are supported by a third party. The downside of control, however, is that it is necessarily accompanied by responsibility. While many advisors have embraced the responsibility of creating portfolios for clients, the implementation of the portfolio can be more troublesome.

Although many platforms are adept at implementing model portfolios, most U.K. advisors do not have discretionary permissions. They need to seek permission for each portfolio change from every client. This requires considerable administrative work, which may hinder an advisor from taking actions recommended by the model portfolio provider. If clients fail to give permission, portfolios may become misaligned with the models. That in turn can have a knock-on impact on reporting and performance. What’s more, advisors tend to use more than one platform, and may have to use different funds to implement portfolios across the platforms they use, or else limit their selections to funds listed on all the platforms they use.

In short, model portfolios typically require advisors to make a considerable investment of time and resources. Such an investment makes sense when advisors define their value proposition as investment specialists. However, an increasing number of advisors are emphasizing their focus on financial planning rather than investing.

Growing Demand for Managed Portfolios
The increasing popularity of passive investment and direct-to-consumer propositions has contributed to the growing commoditization of portfolio services. One driver of this popularity is undoubtedly the poor relative performance of active managers over the past few years, and hence may prove to be cyclical. But a more important secular trend appears to be greater transparency on costs.

Meanwhile, as portfolio services become commoditized, behavioral science is revealing the value of advisors as financial coaches. Advisors can show significant value by engaging with their client on goals-based planning and improving investor behavior. Of course, the challenge of a coaching model is that it requires the advisor to spend more time with clients, necessitating the streamlining of the business model to reduce operational costs.

Such a business model is naturally aligned to a managed portfolio service where both the investment decisions and the execution are undertaken by the portfolio manager on a discretionary basis. Although advisors lose the benefits of presenting their own portfolios to clients, they gain efficiencies and get to “sit on the same side of the table” as the client. They can demonstrate value by critically appraising the work of the managed portfolio provider, while focusing on the financial goals and behavior of their clients.

An Eye for the Future
Both model and managed portfolios have advantages. The right choice is linked to an advisor’s choice of business model. The current environment appears to favor the eventual dominance of the coaching model, which suggests the future dominance of managed portfolios.

The growing interest in managed portfolios is also being boosted by an ongoing decline in costs, presumably as managed portfolio providers use the benefits of scale to reduce the impact of fees on returns. Managed portfolio services still tend to carry higher costs than model portfolios, but the gap is shrinking.

Advisors must be clear about the benefits and drawbacks of each service before recommending one. Ultimately, human relationships have an enduring appeal and a power to change behavior— and that service is very difficult to outsource. 

[1] “You Have Reached Your Destination,” Lang Cat, December 2017.

This article originally appeared in the June/July 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.