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Constructing Climate-first model portfolios
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The art - and science - of building better models
A recipe for model portfolio success
BACK TO THE TOP
Solving for client needs using completion models
Think beyond ordinary tech funds
THE NATIONAL RIA
What makes a good portfolio? Answering that question is not as simple as it may seem. A good model is one that performs well, one might glibly respond – before remembering that performance is something that is assessed with ease and predicted with tremendous vagueness. More to the point is that free markets make inseparable companions of reward and risk, which makes deciding on a portfolio for an investor as much an exercise in risk tolerance assessment as in performance predictions. If predicting is impossible, must we declare the efforts to build better portfolios a fools’ errand? Of course not! Some portfolios are clearly better than others. To give a trite example, the theory of diversification tells us that a portfolio comprised of one stock will offer less reward per unit of risk than a portfolio holding 100 stocks. We also know that a portfolio that sells holdings at a loss so as to offset gains will deliver superior after-tax performance. Such well-grounded ideas form a partial framework for the conversations that follow, though we delve much deeper than that. In fact, I doubt that such a diverse group of discussions about building and managing model portfolios has ever been collected in one place. From the world’s largest asset manager and a small RIA to a national broker-dealer and an esteemed third-party investor, we bring you the insights of some of the brightest professionals building portfolios today. Within the portfolios themselves, you’ll spot some interesting similarities and striking differences. In the conversations printed alongside, you’ll hear thoughtful predictions and questions about how the ‘perfect portfolio’ will change over time. Are 60/40 stock/bond portfolios becoming obsolete? How much should investors diversify their holdings across country lines? Is it time to reach for yield, or cling to safety? It is a rare treat to find so many different answers to these questions – and then to see, in these portfolios’ components, exactly how those answers are expressed in real-world situations. What, then, makes a good portfolio? The question is rhetorical. But as you flip through these pages, we hope to give you an idea of what the answer might be.
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EVOLVED PORTFOLIOS FOR EVOLVED INVESTOR AND ADVISOR needs
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THE BOUTIQUE RIA
Important information About risk Factor investing (as known as smart beta or active quant) is an investment strategy in which securities are chosen based on certain characteristics and attributes that may explain differences in returns. Factor investing represents an alternative and selection index-based methodology that seeks to outperform a benchmark or reduce portfolio risk, both in active or passive vehicles. There can be no assurance that performance will be enhanced or risk will be reduced for strategies that seek to provide exposure to certain factors. Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. Factor investing may underperform cap-weighted benchmarks and increase portfolio risk. There is no assurance that the investment strategies discussed in this material will achieve their investment objectives. The use of environmental and social factors to exclude certain investments for non-financial reasons may limit market opportunities available to portfolios not using these criteria. Further, information used to evaluate environmental and social factors may not be readily available, complete or accurate, which could negatively impact the ability to apply environmental and social standards. For US Institutional Investors This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is being provided for informational purposes only, is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in any investment making decision. This should not be considered a recommendation to purchase any investment product. As with all investments, there are associated inherent risks. This does not constitute a recommendation of any investment strategy for a particular investor. Investors should consult a financial professional before making any investment decisions if they are uncertain whether an investment is suitable for them. Please read all financial material carefully before investing. For additional information about these strategies, contact Invesco. Past performance is not indicative of future results. The opinions expressed are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Invesco Solutions is part of Invesco Advisers, Inc., a registered investment adviser that provides investment advisory services and does not sell securities. Invesco Advisers, Inc. is an indirect, wholly owned subsidiary of Invesco Ltd. Over the last 10 years, as of Sept. 30, 2021, the S&P 500 Index has outperformed the MSCI ACWI-ex US Index. Source, Bloomberg, L.P. The S&P 500® Index is an unmanaged index considered representative of the US stock market. The MSCI All Country World ex USA Index is an unmanaged index considered representative of large- and mid-cap stocks across developed and emerging markets, excluding the US. The index is computed using the net return, which withholds applicable taxes for nonresident investors. Past performance is not a guarantee of future results. An investment cannot be made directly in an index. Invesco.com NA 10,051 10/21 Invesco Advisers, Inc.
Model portfolios are commonly used by financial professionals to create economies of scale, allowing them to spend more time on what matters most to their clients. But the way that models are being used is evolving. They’re designed to be an all-in-one solution, an easy way to provide broad market exposure. And many asset management firms — including Invesco — provide this type of strategy. But financial professionals are looking to provide much more than simple exposure. They’re seeking to create outcomes for their clients that will allow them to meet their financial goals. And many don’t want to place 100% of a client’s assets in a model. That’s where completion models come into play. We believe completion models can help financial professionals create portfolios that meet a wide range of client needs without abdicating full portfolio responsibility to the model provider. Completion models can be used to fill in gaps or add on evolving areas of interest, leveraging the unique capabilities of the provider. The Invesco Investment Solutions team is increasingly being asked about completion models designed for specific client needs. In particular, we’re seeing interest in: - A more dynamic core of US equities to generate return potential - International exposure to add diversification - Bond strategies to boost income potential and manage interest rate risk - ESG strategies that align with clients’ values How can completion models help clients?
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Unlike traditional models that are used to manage entire portfolios, completion models are used to manage specific portions of a client’s assets
“Our team believes that international stocks, especially emerging markets, are poised for improvement over the next 10 years — and that now is the time to ensure adequate diversification globally.”
By Duy Nguyen and Alessio de Longis
Client need #1: A more dynamic US core to generate return potential Having exposure to US core equities is a critical part of most portfolios, but is there a way to make that exposure work harder for your clients over time and across different phases of an economic cycle? We believe that a dynamic factor rotation strategy can provide the potential for favorable risk-adjusted returns over long periods. Factors are measurable characteristics of a security that help explain its performance — qualities such as value, low volatility and momentum. Although factor performance isn’t guaranteed, different factors tend to outperform during different phases of the market cycle. Your clients already have exposure to factors within their US core equity allocation — but the key to moving from exposure to outcomes is understanding how these factors may be impacting performance and making intentional adjustments to align with a client’s goals. Invesco’s U.S. Factor Rotation Model can do that work for you. It invests in five different ETFs, each providing exposure to a different factor: Low volatility, value, quality, size, and momentum. Our team follows a rules-based process to identify economic regime changes and determines the optimal combination of the five ETFs for various economic regime types. Client need #2: International exposure to add diversification The past 10 years has seen US stocks outperform international stocks1, a trend that has led many US investors to adopt a strong home country bias in their portfolios. And the onset of COVID-19 exacerbated the situation. To illustrate the point: Each year, our team works with hundreds of advisors to examine thousands of portfolios and provide feedback and guidance. Prior to COVID-19, the advisor equity portfolios that we examined had close to 30% of their equity allocated overseas, on average. That quickly dropped to just 23.5% during the pandemic, rising slightly to 24.8% in the quarter ending Sept. 30, 2021. But looking ahead, our team believes that international stocks, especially emerging markets, are poised for improvement over the next 10 years — and that now is the time to ensure adequate diversification globally. By diversifying across different asset classes, styles, and market capitalizations in these markets, investors may benefit from exposure to a broader range of opportunities. Our International Diversification Equity Model aims to solve for home country bias by investing in a range of active and ETF strategies, providing broad international equity exposure across market capitalizations and styles, and in both developed and emerging markets. Our International Diversification Blend Model adds international fixed income strategies to the mix.
Client need #3: Bond strategies to generate income potential and manage interest rate risk One of the biggest risks of holding fixed-coupon bonds is that interest rates may rise, which lowers the value of any bond with a coupon below the current market rate. Laddered bond portfolios can help with that risk. A laddered portfolio consists of bonds with varying terms to maturity, often with a consistent period of time between each maturity. By creating such a portfolio, an investor will have bonds maturing periodically. This strategy is designed to address some of the main concerns of fixed income investors, including interest rate risk. Since bond ladders generally hold a number of bonds with different maturities, investors can use the maturing proceeds to invest in current rate issues, taking advantage of the higher rates. Creating bond ladders can be time-consuming: The credit quality of the issuer must be reviewed, and researching such characteristics as cash flow and optionality takes time. Our team simplifies this process for clients by creating ladders using defined maturity ETFs, which invest in a variety of corporate or municipal bonds of the same maturity date, and holding the bonds to maturity. Our laddered bond models provide customized corporate/municipal bond portfolios tailored to specific maturity profiles, risk preferences and investment goals. They are designed to be evergreen across four maturity bands: 0-3 years, 0-5 years, 0-7 years, and 0-10 years. Three completion models to help meet client needs
Growing interest in ESG strategies that align with clients’ values As different client needs arise, we will look for ways to create new client-centric completion models. One area where we see growing interest is in ESG — environmental, social and governance strategies. ESG brings with it a long list of new vocabulary to learn, including exclusionary screenings, sustainability-focused solutions, impact investing and broad ESG integration. This is the type of area that we believe is ready-made for a completion model solution, where financial professionals can turn to asset management providers, like Invesco, who have a history of expertise in the category. Why Invesco for completion models Invesco Investment Solutions is a global team with 20+ average years’ experience across team leadership. Invesco Ltd.’s US$1.5 trillion investment management platform2 puts us in an excellent position to offer a vast array of investment solutions to fit almost any investor need. Simply put, Invesco has a wide array of capabilities in equities, fixed income, alternatives, and more, and our team has the ability to pick and choose from these broad capabilities as part of our multi-manager selection process, which is illustrated on the next page. Invesco Investment Solutions: Manager selection process
Duy Nguyen, CFA®, CAIA Duy Nguyen is Chief Investment Officer and Senior Portfolio Manager for the Invesco Investment Solutions team, which provides customized, multi-asset investment strategies for institutional and retail clients. In this role, he is responsible for the overall strategy and direction of the team’s investment process. This involves guiding the research agenda, overseeing all portfolio implementation quality, and communicating the investment process to internal and external teams. Mr. Nguyen also oversees the team’s client solutions development efforts, using the team’s collective experience in asset allocation, portfolio construction, and research and analytics with the goal of cultivating advisory relationships and building custom solutions that are outcome-oriented and investor-focused. Alessio de Longis, CFA® Alessio de Longis is a Senior Portfolio Manager for the Invesco Investment Solutions team. In this role, he provides customized multi-asset investment strategies for institutional and retail clients. He is focused on global macro tactical asset allocation, factor strategies, and currency overlays.
SEI, whose name was originally an acronym for ‘Simulated Environments Inc,’ is known among advisors as one of the major Turnkey Asset Management Progams (Tamps). Today, SEI has broadened out its offerings and prefers to be known as a ‘techstodian.’ However, it still manages investments on behalf of RIAs through the use of SMAs held in each client’s name. In this interview, SEI’s J. Womack explains the firm’s investing process and dives into a tax-aware version of the 60/40 portfolio. Why the emphasis on tax awareness in this (and other similar) strategies? ‘If you’re coming to us and you’re choosing to outsource investments,’ Womack said, ‘we want to make it really easy for you to align strategies with your client’s goals.’
What kinds of clients was this portfolio designed for? For many advisors, their clients will be in the upper end of the mass-affluent market. And as someone accumulates wealth in tax-advantaged accounts – 401(k)s, IRAs, etc – they may have excess funds that they want to invest in on an after-tax basis in a taxable account, or they may be in a position where there’s a particular goal that they’ve got in mind for money over time. So it’s really about trying to help meet the needs of clients who either have excess funds to invest or who have a particular goal that requires after-tax funds to achieve. In other words, these strategies came from understanding the household balance sheet, the client wealth cycle, and the specific needs that clients have when they come to advisors at different times. Why did you choose to go with different ETF providers for different slices of the portfolio? Just to zoom out a little, there are a couple of things that we want to try to achieve. One is diversification – at a sub-asset-class level, but also, to some extent, from a provider perspective. We’re one of the largest ETF strategists in the market. We want to make sure that we’re able to trade efficiently. So diversification across providers is a benefit at some level. ETFs are highly liquid. The underlying is typically highly liquid. We’re not in exotic parts of the spectrum. That said, we do just want to be aware of our impact from a trading perspective. The second thing is, for any particular provider or any particular ETF, we’re looking at liquidity. Sometimes, if we’re going to trade large positions, they are very large trades and there’s process around notifying the sponsor, ultimately making those trades, allocating them to client accounts. So we want really liquid names that we can trade very quickly without moving on the screen, and maybe even getting beneficial trading from an implementation perspective. If you look at the majors, I’d say that by and large, across most of the sub-asset classes represented here, pricing differences are marginal. Performance differences are almost nil. So it’s really about efficiency for us and for advisors.
It does seem that emerging markets, especially emerging market bonds, might be a particularly challenging place to invest passively. Well, we do know from the academic research that asset allocation drives about 94% of the variation in outcomes among client portfolios. What’s most important here is the exposure. I’d add that when you look across the majors in particular and the resources that they bring to bear for these exposures, there’s a degree of prudence there. But your point is well-taken. If you were asking for our best advice in these contexts, we’d say that there’s an opportunity to go active in something like an emerging market bond sub-asset class or something like a high-yield muni sub-asset class. In this portfolio, what we’re going for is trading efficiency and cost efficiency for advisors who are looking for something simple that they can confidently represent to their clients. Let’s talk about the significant municipal bond exposure. Clearly, the tax advantages are front of mind, but are there idiosyncratic risks that this portfolio is exposed to as a result? At the highest level, I think by going into a bond ETF, there’s built-in diversification. There is idiosyncratic risk, probably, on a relative basis, and that’s important. Relative to a national bond exposure, if you’re going to go state-specific, I think you’re much more exposed to that idiosyncratic risk associated with a state. There are obviously benefits to holding particular state bonds, if you’re a resident and turnover in those particular ETFs from a name perspective is relatively low. Now in Q1 of 2020, there was this issue of lack of bids. Liquidity dried up in certain segments of the fixed income market – but the same was true for offers on US Treasurys. When you do these really big liquidity shock events, that’s obviously going to impact bond ETFs along with individual bonds, so it’s something to be aware of. That’s why we spend so much time really focusing on liquidity, both of the instruments themselves and the underlying. We don’t want to get caught offsides in those situations.
Tell us about this US equity slice. Why the four Vanguard ETFs instead of a product like VTI? It’s fundamentally about the degrees of freedom that you get to provide the tax-loss-harvesting benefit. This gives us more opportunities to provide after-tax alpha to clients. You see divergences between value and growth, small and large, and as those things happen, we really want to be able to take advantage of those dynamics. Losses can play a key role in providing real benefits to support rebalancing and minimizing the impact of taxes in strategies. Tell us about how you rebalance. Is it a big rush at the end of the year? No! We fundamentally believe in the importance of maintaining asset allocation, but doing so in a tax-aware way. We have tolerances that we set for different sub-asset classes so that when the allocation to particular sub-asset classes breaches those thresholds, we rebalance back to target. That’s something that we monitor every day. So it’s not calendar-based rebalancing; it’s rebalancing as a function of drift in the underlying strategy, which is critically important. We really want to focus on maintaining the asset allocation because, again, that’s what’s going to drive a lot of the variation in portfolio performance over time, and we think that there’s alpha in rebalancing, so we do it all the time. Are there any significant changes you’re considering making? Not to this particular strategy family, which we’ve been managing for a little over six years now. We’ve gotten great adoption among advisors, and we get incredible feedback from RIAs and broker-dealer-affiliated advisors alike. So we don’t plan on making changes anytime soon. We think these provide great value, and we don’t see the same types of solutions in the marketplace from other providers, in terms of combining muni exposure with ongoing tax harvesting and the ability to substitute funds for different clients. That differentiation has been a durable one. Tell us about this US equity slice. Why the four Vanguard ETFs instead of a product like VTI? It’s fundamentally about the degrees of freedom that you get to provide the tax-loss-harvesting benefit. This gives us more opportunities to provide after-tax alpha to clients. You see divergences between value and growth, small and large, and as those things happen, we really want to be able to take advantage of those dynamics. Losses can play a key role in providing real benefits to support rebalancing and minimizing the impact of taxes in strategies. Tell us about how you rebalance. Is it a big rush at the end of the year? No! We fundamentally believe in the importance of maintaining asset allocation, but doing so in a tax-aware way. We have tolerances that we set for different sub-asset classes so that when the allocation to particular sub-asset classes breaches those thresholds, we rebalance back to target. That’s something that we monitor every day. So it’s not calendar-based rebalancing; it’s rebalancing as a function of drift in the underlying strategy, which is critically important. We really want to focus on maintaining the asset allocation because, again, that’s what’s going to drive a lot of the variation in portfolio performance over time, and we think that there’s alpha in rebalancing, so we do it all the time. Are there any significant changes you’re considering making? Not to this particular strategy family, which we’ve been managing for a little over six years now. We’ve gotten great adoption among advisors, and we get incredible feedback from RIAs and broker-dealer-affiliated advisors alike. So we don’t plan on making changes anytime soon. We think these provide great value, and we don’t see the same types of solutions in the marketplace from other providers, in terms of combining muni exposure with ongoing tax harvesting and the ability to substitute funds for different clients. That differentiation has been a durable one.
It’s common to see global diversification on the equity side, but it’s a bit unusual to see emerging market bonds in a portfolio like this. When you think about diversification globally, if you’re targeting global exposure, it means that you think about emerging markets very specifically, and that does a couple of things for you. One is around that sensitivity to equity volatility; it’s a different risk profile, which has correlated or associated return characteristics that are available. I think the other piece is what I’d call commodity sensitivity. Emerging market (EM) exposure gives you a little bit of sensitivity to inflation, or at least to commodity-type exposure. So that’s why EM. When you think about local currency versus US dollar-denominated, it’s really about diversifying the exposure along the two dimensions that you can get in EM, which at some level is trying to participate more directly in some of that inflation sensitivity. But also, we’re cognizant of the fact that we’ve got dollar-based investors, so we don’t want to go full bore into local currency. We want to be really cognizant and deliberate about the risk that we’re taking and not taking in the context of these asset allocations.
An approach that combines clients’ financial and sustainability goals
Constructing climate-first model portfolios
Jean-Maurice Ladure
As a growing number of investors sharpen their focus on addressing climate change, wealth managers are increasingly mapping out strategies aimed at aligning portfolios with their clients’ objectives of cutting global carbon emissions to net-zero and enabling sustainable technologies. For decades, advisers have taken advantage of a wide array of model portfolios designed to address their clients’ financial goals. But the needs and preferences of investors who want their investments to help produce a net-zero economy or generate positive, measurable social impact may call for strategies that straddle standard offerings. Investors’ commitments to climate change can vary in intensity. They may want to address environmental, social or governance (ESG) concerns that reflect their goal of a socially responsible society while preventing the risks associated with a warming planet. Or they may want to have a more direct impact and invest in climate-solutions companies, all without significantly altering their financial objectives and tolerance for risk. Designing strategies to achieve such goals may require wealth managers to personalize portfolios in ways that static models alone cannot address. As awareness of the financial impacts of climate change grows, advisers may gain a competitive advantage when creating portfolios that help clients use their wealth to address sustainability objectives. Illustrating a climate-first approach Advisers can apply a climate-first approach consistently across client risk profiles, from cautious and balanced, to aggressive and equity. A model portfolio can draw on two components: - A core sleeve with a mix of equities and bonds that broadly integrates climate and ESG considerations. -An impact sleeve with a mix of assets that reflects the investor’s specific climate and green solutions preferences. Imagine, for example, a client with a balanced portfolio who allocates 60% of their investment to equities and 40% to bonds, and who decides to put money toward companies that show resiliency in both ESG and climate. An adviser can incorporate that preference into the client’s investment portfolio broadly, for instance, by allocating 100% of equity and bond investments to a core sleeve divided equally between ESG and climate mandates. Alternatively, the client might prefer to focus the portfolio’s impact on climate and green solutions. In that case, the portfolio could invest 25% of the impact sleeve in such solutions and tilt the core sleeve toward climate. The preference can be refined by its intensity, as measured by the weighting and composition of the core and impact sleeves. For illustration, we can compare the two underlying ESG and climate preferences to a market-capitalization (market-cap) reference for each of four risk profiles, based on each portfolio’s carbon footprint, resilience to ESG risks and financial performance using the performance of nine MSCI indexes from May 2014 to August 2021.*
Managing Director, Index Solutions Research
Less warming, more impact The climate-first approach cut the portfolios’ carbon footprint by as much as 40%, depending on the client’s preference and its intensity. The balanced mandate with a core allocation for ESG and climate, for instance, lowered the portfolio’s greenhouse gas emissions by 35%.
Switching part of the core sleeve of the hypothetical portfolios’ preference to the impact one left their carbon footprint roughly unchanged. As the following chart shows, however, the change nearly doubled the amount of revenue portfolio companies earn from renewable energy, electric cars and other businesses linked to a clean-energy economy. The change quadrupled such revenues compared with a market-cap-only portfolio.
Boosting ESG credentials The integration of ESG in the core sleeve helped the climate-first model portfolios achieve significant improvements in resilience to long-term ESG risks, as measured by the improvement in both ESG scores and ratings (to AA from A) across each of the risk profiles.
Note that ESG scores ticked down slightly when the portfolios boosted the allocation to climate and green solutions. That reflects a trade-off between allocating to companies that earn a significant share of green revenue compared with those that have high overall ESG ratings. Financial performance The climate-first portfolios improved sustainability significantly, without taking on more risk or surrendering performance. As the chart below shows, a 60:40 portfolio combined with an ESG and climate core preference outperformed its market-cap-weighted benchmark by 45 basis points (bps) per year, with less risk, during the period of illustration.**
Though the impact portfolio proved slightly riskier, it outperformed the market-cap portfolio over the same period by an average of 130 bps across all risk profiles during the illustration period. The outperformance reflected the choice to reallocate capital to companies that earn the bulk of their revenue from alternative energy or other sustainable businesses and away from fossil-fuel businesses. The added risk reflected the concentration of capital in the smaller set of companies that derive significant shares of revenue from green businesses. For both core and impact, the portfolios achieved their improvements with tracking error of less than 0.9% and 2.2%, respectively. The risk profiles of both intensities remained in alignment with the hypothetical client’s starting point. Wealth managers can use data and analytical tools from MSCI to help clients examine whether a climate-first portfolio embodies their preferences and track its progress. That may include showing investors whether a particular portfolio aligns with global temperature targets, or showing them how risks and opportunities from climate change might impact the valuation of companies. Managers using a climate-first approach can develop strategies that match the unique preferences of clients who aim to use their wealth responsibly, while enabling the manager to recommend allocations that respect the client’s investment objectives and appetite for risk. This can strengthen the readiness of managers to advise clients who seek to slow climate change and improve sustainability as part of their investment decision-making.
* The analysis uses this time period, the longest for which data is available for all nine indexes it covers, for consistency across each of the hypothetical portfolios. The indexes are the MSCI USD IG Corporate Bond Index, ESG Leaders Corporate Bond Index, Climate Change Corporate Bond Index, ACWI Index, ACWI ESG Leaders Index, ACWI Climate Change Index, ACWI IMI Smart Cities Index, Global Energy Efficiency Index and Global Green Building Index. ** We note that this is a hypothetical scenario using historical data and that actual performance may differ significantly. Past performance is not indicative of future results. The information contained herein (the “Information”) may not be reproduced or redisseminated in whole or in part without prior written permission from MSCI ESG Research. The Information may not be used to verify or correct other data, to create any derivative works, to create indexes, risk models, or analytics, or in connection with issuing, offering, sponsoring, managing or marketing any securities, portfolios, financial products or other investment vehicles. Historical data and analysis should not be taken as an indication or guarantee of any future performance, analysis, forecast or prediction. MSCI ESG Research is provided by MSCI Inc.’s subsidiary, MSCI ESG Research LLC, a Registered Investment Adviser under the Investment Advisers Act of 1940. MSCI ESG Research materials, including materials utilized in any MSCI ESG Indexes or other products, have not been submitted to, nor received approval from, the United States Securities and Exchange Commission or any other regulatory body. None of the Information or MSCI index or other product or service constitutes an offer to buy or sell, or a promotion or recommendation of, any security, financial instrument or product or trading strategy. Further, none of the Information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The Information is provided “as is” and the user of the Information assumes the entire risk of any use it may make or permit to be made of the Information. NONE OF MSCI INC. OR ANY OF ITS SUBSIDIARIES OR ITS OR THEIR DIRECT OR INDIRECT SUPPLIERS OR ANY THIRD PARTY INVOLVED IN THE MAKING OR COMPILING OF THE INFORMATION (EACH, AN “INFORMATION PROVIDER”) MAKES ANY WARRANTIES OR REPRESENTATIONS AND, TO THE MAXIMUM EXTENT PERMITTED BY LAW, EACH INFORMATION PROVIDER HEREBY EXPRESSLY DISCLAIMS ALL IMPLIED WARRANTIES, INCLUDING WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE. WITHOUT LIMITING ANY OF THE FOREGOING AND TO THE MAXIMUM EXTENT PERMITTED BY LAW, IN NO EVENT SHALL ANY OF THE INFORMATION PROVIDERS HAVE ANY LIABILITY REGARDING ANY OF THE INFORMATION FOR ANY DIRECT, INDIRECT, SPECIAL, PUNITIVE, CONSEQUENTIAL (INCLUDING LOST PROFITS) OR ANY OTHER DAMAGES EVEN IF NOTIFIED OF THE POSSIBILITY OF SUCH DAMAGES. The foregoing shall not exclude or limit any liability that may not by applicable law be excluded or limited. Privacy notice: For information about how MSCI collects and uses personal data, please refer to our Privacy Notice at https://www.msci.com/privacy-pledge
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With 50 offices nationwide and some $11bn in advisory and brokerage assets, Integrated Partners is a Massachusetts-based RIA with a national footprint. The firm’s CIO, Rob Brown, has led a storied career that includes major roles at Goldman Sachs, SEI and the CFA Institute. He also holds a PhD in finance from Northwestern University. Perhaps it’s this pedigreed background that gives Brown the confidence to build and maintain this wildly idiosyncratic portfolio. He explains its methodology and holdings in this conversation.
Why do you use model portfolios at Integrated Partners? We use model portfolios so that our advisers can spend their time working with clients to do financial planning. The truth of the matter is, the advisors’ greatest possible contributions are in areas like goal-setting and behavior modification. It’s not in investments. So, by delivering model portfolios, we’re able to relieve them of that task. I think anyone who glances at these holdings could tell that this isn’t your typical model. What’s the philosophy behind this portfolio? If you want it just in a single phrase, it’s: winners repeat, losers repeat. It’s as simple as that. It is the historical observation that all major asset categories – stocks, bonds, currencies, commodities – it’s true today, it’s been true for the last 100 years – there is an incredibly strong propensity that those asset categories that have been relatively winning, have a strong propensity to win for just one more period, and the same thing for the losers. In other words: markets trend. It doesn’t get much more rock-solid than that. It’s just one of those rewarded factors. Then it’s a question of how you access it in an effective way so that you can end up with some fairly miraculous results. You can think of it in the context of a bull or a bear market, or focus just on bear markets for the US. What’s a typical bear market here in the US? Do stocks go down for a month or two or three? No. A typical bear market in the US goes on for 18 or 19 months. That’s an average, run-of-the-mill, middle-of-the-fairway bear market. What’s that going to do if you’re building a ‘winners repeat, losers repeat’ strategy? Simple: If we get you out of stocks and put you into bonds, you’re in a better position and you win. I’ve got to ask whether the Covid crash was tough on this sort of strategy. It was. Generically, when you look across all of the tactical asset allocation strategies in the industry, collectively, they did quite poorly during the Covid crash because it lasted 33 days. That was 33 calendar days, not even 33 trading days. So most of them were positioned quite poorly. This particular strategy, actually, blew the lights out during that. Dumb luck as opposed to brilliance. It’s because this is specifically designed to think across stocks, Treasurys, corporate bonds, and commodities. Treasurys started doing better several months earlier. So it was already repositioning away from stocks and into Treasurys and, in particular, into long Treasurys – meaning that when stocks started falling off the edge of the cliff in early February, it was well-positioned. It worked brilliantly during those 33 days.
Speaking of contrarian, I notice the big outsized holding in energy stocks and in Canada, which of course is very fossil fuel-centric. It’s funny because energy, even a few months ago, seemed to have been left for dead. It’s had a profound rally, but it still makes up a much smaller percentage of the market than it used to. No kidding. Investors and many advisors forget the extent to which funds tracking indexes like the S&P 500 are the ultimate in terms of turning from a cow into a chicken into a fish into veggie in terms of their complexion. Back at its peak in the 1980s, energy was 28.5% of the S&P 500; today, it’s up a tiny bit, but it was bottoming out at just a hair over 2% of the S&P 500. Really! Meanwhile, where’s technology? They slipped Amazon and Facebook out of the technology index because it was looking so weird, but if you stick them back in, technology is 33% of the S&P 500. We’ve done this before. Before this, financials were 33%. Before that, we had energy at 28.5%. It’s crazy. So getting back to this portfolio: Winners repeat, losers repeat. That quickly pulls in things like energy as it began to take off from its low, and it’s certainly been a huge driver for success. It remains in the portfolio, and that’s also one of the contributing elements for Canada being in there as well.
I don’t see agriculture in a portfolio every day. Empirically, historically, as an asset category, it’s incredibly useful and it’s incredibly powerful as a complementary ingredient. You don’t use them all the time, but from a complementary standpoint, it has very useful attributes, particularly when inflation is raising its head. But yes, you don’t generally see it. In fact, it’s very rarely used because any of the sensible agriculture ETFs generate K-1 reports. Generally, that’s verboten. This is one of the rare portfolios we run that generates K-1 reports, and everybody knows it may generate a K-1, so they’re ready for that. Tell us a bit more about the methodology. Is this portfolio run quantitatively? It’s 100% quantitative, 100% rules-based and 100% transparent. There are no secrets – we’ll show anything to everybody, which, in our view, is necessary. Any time an investment manager is stepping forward and says ‘it’s proprietary, we can’t show you,’ you know that there’s something fishy going on. In this industry, there are almost no secrets whatsoever. More importantly, the rules-based nature of it means it’s completely testable through time. We can go back and we can ask and rigorously answer the question: Okay, how did it do during the 1960s, when inflation was taking off, there was social upheaval and we had simultaneous back-to-back recessions? Or: How did it do during the 1930s, when the Great Depression took off and unemployment spiked at 25%? Those questions can absolutely be rigorously answered. We know exactly how it would have done, because of the straightforward simplicity of the rules. How do you define the universe for those rules? What potential holdings can this portfolio choose among? For an approach like this to work, you need asset categories that actually behave differently. For example, you could say, ‘I need to have small cap, I need mid-cap, and I need to have large cap.’ Wrong. Those don’t behave differently enough. It’s far better that you actually go with industry sectors like energy versus technology versus healthcare versus utilities versus real estate. Those behave very differently. Whereas with small cap, mid-cap, and large cap, they often behave similarly, so you’re not getting that differentiation. You also need to take into account trading costs. There are things you avoid because the trading costs are too high. That’s a challenge of commodities. Finally, you need to have enough engines of growth and you need to have enough safe harbors. So, you’ve got to have enough kinds of Treasurys, corporates, and some international bonds. Then you’re bringing in important currency phenomena because there have been and will be times when the US dollar is the worst place to be on the planet. You need to have an adequate expression of international countries because, again, more than half the time, international does better than the US. And commodities are incredibly helpful from a complementary, temporary standpoint.
Getting back to the first question, I’m wondering whether it ever gets tricky when this portfolio shifts dramatically in risk exposure. How does that work between you and the advisor, or between the advisor and the client? One question there is: What is the nature of the relationship between the client and advisor? Most of the time, that topic doesn’t come up. The client didn’t hire the advisor to talk about investments and get into, ‘how much do I have in stocks?’, ‘how much do I have in bonds?’ and that kind of stuff. No, the client knows the advisors will do right by them, because they’re focused on financial planning and estate planning and tax management and the next generation and all the rest. But sometimes the client wants to know or needs to know, and the advisor has to decide whether the client can get comfortable with the fact that during rising markets, the allocation to equities is going to go up, and during falling markets, the allocation to equities is going to go down. Some clients want that. Some clients are uncomfortable with it because they’re worried that a mistake will be made, and they’d rather just ride the markets up and ride them down. Well, that’s just a discussion that the advisor and the client have to have about what can they live with. Some fall in one category and some fall into the other. Some just have to have fixed weights, although I’d add that may be particularly difficult in the period ahead. Why? Well, because it’s pretty easy to paint a scenario where, for the first time in the lives of virtually anybody who’s around today, we will have a stock bear market and a bond bear market at the same time – in which case, fixed-weight portfolios are going to suck at both ends. It’ll be the end of the 60/40 portfolio as we know it. Because if you look at the historical data, the average bond bear market is negative 36%. You combine that with an average stock bear market, and the 60/40 portfolio looks pretty bad. So it’s like, what do you want? Do you want your fixed-weight portfolio and get whacked on both sides of it, or do you want something that’s actually adapting?
Cetera Financial comprises five broker-dealer groups, and Cetera Investment Management provides model management, manager research, and market perspectives to these broker partners. Within the group, Brian Klimke leads portfolio construction and market strategy, reporting to Gene Goldman, Cetera’s director of research and chief investment officer. Goldman’s team is responsible for the firm’s research and maintaining a high conviction list, which is used to build the models. In this interview, Klimke delves into his team’s approach to portfolio construction and the strategies it selected for the tactical moderate model portfolio, which he said is designed to make up ‘the ballast’ of certain clients’ portfolios.
What’s your approach to model portfolios overall? How do you use them? I think the key is no surprises. We want to create core portfolios for our advisors. In doing that, we really don’t alter our stocks, bonds, and cash mixture. We created an aggressive portfolio that’s 100% equity, minus a 3% cash position for advisor fees. And then we ratchet down the equity by 20% increments until we get to conservative, which is a 20% equity model and 80% fixed income model. Within the tactical models that I’m talking about, we source a liquid alternative position out of equities, so we can manage the beta of the exposure through that liquid alternative exposure. It all starts with the strategic asset allocation models. There is usually a three-to-five-year outlook when we’re building these portfolios, and we make changes about once a year. We can do it more often, but it’s very, very strategic. The tactical portfolios take that three-to-five-year outlook, and then we overlay a one-to-three-quarter outlook, and we’ll shift the portfolio, usually on a quarterly basis, around what we think is going to happen in the next quarter to three quarters, and just adjust around the edges. It’s not extremely tactical; it’s just more tactical than our strategic portfolios. Why did you add a liquid alternative element to this fund? We just think it’s a good way to control risk, and it provides diversification because the strategies, especially in the manager we’re using right now [Blackstone], they’re really using non-correlated strategies where we can offer some diversification away from equities and fixed income. Tell me about the bond exposure. Many people have moved away from high-duration holdings over the past few years. Within the bond portfolio, we’re using two main bond funds. We’re using John Hancock and we’re using a Thornburg fund. We’re reducing the amount of credit risk we have because credit spreads are pretty tight and yields are pretty low. We also have a high yield fund that is more conservative. We are also using a shorter, limited-duration fund. And the reason for that is what we’ve seen since the pandemic: a lot of government debt has been adding a lot of duration to indices. We’re looking to underweight duration compared to the index and compared to our benchmark. We currently have a duration of about five in the portfolio. We still like duration. It’s a good hedge against equity volatility. But we’re underweight duration. We get the duration question a lot from advisors, because many people are scared of bond markets. Yields could rise with inflation expectations. In the 1950s, we had high debt levels, just like today. Coming out of World War II, yields were very low, like today. It was a challenging environment; as bond yields rose, bond prices fell. But overall, bonds were a good hedge against equities, which did extremely well. And we’re kind of looking at that environment, where hopefully equities continue to perform – but if they don’t, the only hedge that you might get is that bond exposure. As yields increase, we will add duration, slowly over time. But currently, we’re underweight.
Tell us about the equity slice. How did you select these funds? Within our large-cap growth, we use a highly concentrated manager that owns about 20 stocks. We can avoid some of the high-flying names. I think right now it’s an important time to be active and really think about things a little bit differently. Indices are being driven by a lot of the same stocks. The top five stocks make up roughly 25% of the S&P 500 right now. So, we kind of wanted more diversification than that. Another observation is that some huge names in technology got reclassified in the GICS sectors into the communication services and consumer discretionary sectors. If we take those three sectors and add them up, they’re at levels that we haven’t seen since the dotcom bubble. So, we’re looking to really diversify our tech exposure. We want technology, we want those names, but we don't want necessarily all of them because valuations are pretty high. Many people have transitioned to passive funds for the big beta holdings in their portfolios. Can you expand on your rationale for active management? In addition to mitigating tech saturation, we’re also looking for diversification. At one point, the top two holdings in the Russell 2000 were meme stocks. But active management understands what’s happening. An index is just going to allocate to whatever, based on market cap, right? And, especially on the fixed income side, that can get perplexing. But on the equity side, these meme stocks became the top holdings of the Russell 2000. With active management, we can get away from that; we can do fundamental analysis and actually dig into what we own.
How does your team view fund fees? We’re definitely looking at fees when we do our manager research. We’re checking to see what the fees are in comparison to performance. But people often get a little too wrapped up in fees. I think fees are very, very important, don’t get me wrong. But I feel like there’s another piece of the equation: what do you get for those fees? Because you’re paying for somebody’s research, you’re paying them to dig in and do fundamental research. If you don’t want to pay that fee, you’re not going to get that service. I feel like I’m getting a lot of calls from advisors who had been indexers but are rethinking it, coming out of this recession, since they’re realizing that things may look a bit different going forward. Are there any significant changes you’re considering making to this portfolio? We generally rebalance this portfolio quarterly, and we can do it more or less often if there’s a big market movement. We were adding to international where it has better valuations and less tech exposure. We think if there was a reversal in the US dollar, that’s going to help international investors as well. But right now, we like our current positioning. If we did see yields rise a lot, we would probably increase our intermediate bond and decrease our short-term bond, and just increase the duration of the portfolio. We are watching inflation carefully.
Model portfolios are playing an increasingly important role in many advisors’ practices, improving scalability and ensuring a more consistent client experience. There are other benefits, too. Financial professionals surveyed by the Natixis Center for Investor Insight indicate that 45% use models to access a wider range of asset classes more efficiently and 42% find that using models lowers the administrative burden.* But as models become more mainstream, advisors are raising the bar for their portfolio providers. These rising expectations come as no surprise to Marina Gross, Co-Head of Natixis Investment Managers Solutions. Her consulting team has analyzed more than 15,000 advisor models since 2012. “Over the years our in-depth reviews have provided some unique insights into the way advisors view risk, asset allocation, manager selection and portfolio returns,” she notes. “Advisors are growing more sophisticated in their use of models and they do expect more.” Addressing these concerns has helped guide and inform innovation and portfolio construction in the Natixis models. DIVERSE NETWORK OF MANAGERS Gross points out that building and managing models leverages other key strengths of Natixis Investment Managers. Thanks to its multi-affiliate structure, independent thinking is part of the Natixis DNA. “We’re fortunate to have highly skilled and experienced management teams who are well-versed in multi-asset portfolio construction. We have a broad network of active managers to choose from – as well as a rigorous due diligence and manager review process to identify best-in-class passive strategies and non-affiliated managers when necessary.” GUIDING PRINCIPLES: ACTIVE AND PASSIVE The Natixis models reflect the belief that strategic, qualitative diversification is essential for pursuing alpha potential and managing risk. “Access to multiple asset managers supports meaningful diversification that reduces the chance of investments being managed in the same way,” says Christopher Sharpe, Chief Investment Officer and Portfolio Manager. He adds that as technology continues to increase the efficiency of the capital markets, restricting a portfolio to an all-active or all-passive strategy shortchanges investors because there are distinct benefits and risks associated with both investment approaches. In Sharpe’s view, “There is significant investment value to be gained from combining active and passive strategies, not only in the form of improved cost and tax efficiencies, but also in the ability to flex the portfolio across exposures, styles and time horizons to create more balance and broaden the opportunity set.” CASE STUDY: TACTICAL CORE MODELS In the Tactical Core Models, the core holdings are actively managed funds, and ETFs are used to express the tactical views driven by the Natixis Investment Managers Solutions Investment Committee’s recommendations. For example, during the third quarter of 2020, the portfolios capitalized on two trends driven by the ongoing Covid-19 pandemic, as identified by the Investment Committee: - Overweight US large cap and small cap equity relative to the benchmark, as the global growth outlook favored the US, with room for additional fiscal and monetary support. Small caps would likely benefit disproportionately from a vaccine, and large caps – especially with growth exposure – were best insulated from any virus flare-ups. - Underweight international developed and emerging markets equity, as a second virus wave in Europe was dimming growth prospects for international equity. Uneven efforts to contain the virus across emerging markets were also hampering growth. CONSISTENT MODEL PORTFOLIO CONSTRUCTION PROCESS
The Art – and Science – of Building Better MODELS
Source: Natixis Investment Managers Solutions
DIVERSE RANGE OF STRATEGIES TO TARGET ADVISORS' NEEDS Differences in model type, construction and allocation in the Natixis models create a robust menu of portfolio options that can be used as core, completion, or thematic portfolios tailored to a range of risk profiles. Once the model type has been selected, the construction approach can be either quantitative or fundamental, the allocation approach can be either dynamic or strategic, and the tax strategy can also be specified. For example, the construction approach of the Tactical Core Models is fundamental, the allocation is dynamic, and the portfolio is tax-aware. These variations result in a broad range of models suitable for almost any type of advisor practice. For example, experience from portfolio consulting has shown that advisors are least confident in choosing alternative investments – although they understand the need for them. This led to the creation of the Alternative Completion Models, designed as a “plug and play” allocation that aligns with the risk profile of a client’s core portfolio. The offering also includes thematic models that focus on sustainable investing and income generation. “Responding to the needs of advisors and their clients has been the driving force behind growing our model business,” says Marina Gross. “We expect that advisors will continue to demand more from their model providers in the years ahead.”
DIVERSE NETWORK OF INDEPENDENT AFFILIATED MANAGERS Natixis Investment Managers affiliates include high conviction active managers across equities, fixed income, REITs and alternatives, including tax-aware, ESG and sustainable strategies. AEW – Global real estate securities strategies AlphaSimplex – Alternative investment solutions Gateway – Low volatility equity strategies Harris Associates (Oakmark Funds) – US, international and global equity strategies Loomis, Sayles & Company – Fixed income, equity and alternative investments Mirova – Sustainable, conviction-driven equity and fixed income strategies Vaughan Nelson Investment Managers – US, international and emerging market equities WCM – International and global growth equity investments To see the full model offering or learn more about the managers, visit natixisimsolutions.com/models or call 800-862-4863
*Natixis Investment Managers, 2020 Global Survey of Financial Professionals, conducted by CoreData Research March-April 2020. Survey included 2,700 financial professionals in 16 countries. The views and opinions expressed may change based on market and other conditions. This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary. Investing involves risk, including the risk of loss. Please read the risks associated with each investment prior to investing. Natixis Advisors, LLC provides advisory services through its division Natixis Investment Managers Solutions. Advisory services are generally provided with the assistance of model portfolio providers, some of which are affiliates of Natixis Investment Managers, LLC. Natixis Advisors, LLC does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decision. natixisimsolutions.com. Copyright © 2021 Natixis Advisors, LLC - All rights reserved
How does the world’s largest asset manager use model portfolios? For BlackRock, model portfolios serve to encourage investment into its funds. Its model portfolios collectively hold $81bn in assets under management, mostly through asset management platforms. In this interview, BlackRock lead portfolio strategist Tushar Yadava talks about the thinking behind this flagship 60/40 strategy, as well as some of its nuances and investment choices.
How do you think about international exposure in this portfolio? It starts with the selection of benchmarks. Instead of the MSCI All-Country World, which has about a 55% weight to the US normally, we up-weight it to about two-thirds US and one-third international. So all we’re doing is, instead of 60% in the MSCI ACWI, we actually have 42% in the MSCI ACWI and 18% in the MSCI USA, and that’s our benchmark approach. For US households, this makes a little more sense, since their revenue stream is denominated in US dollars, their real returns should be in US dollars and their liabilities are in US dollars. So, we’re trying to match up the portfolio with what their needs are. Also, from a behavioral standpoint, it’s a little bit more sensible for them because they’re more tied to what’s going on in the US market, so they’re more likely to stay the course if they understand their investments from that standpoint as well.
In terms of specific holdings, this sizable allocation to the ESG Aware ETF stands out. The construction of this ETF is really interesting. It’s the first toe-dip into the water of ESG. What I mean is, this doesn’t do very much in terms of the exclusionary side – what it’s doing is reweighting the components of the index by their composite ESG score. Then it constrains it by stock and by sector, and it allows for only 50 basis points of predicted tracking error. So this should look like the MSCI USA with only 50 basis points of tracking error based on our reweighting, according to the ESG metrics. We like it because we think the ESG screens themselves are additional risk screens that help on a standalone risk basis. The punchline here is that in 2020, when we added this ESGU ETF to the portfolio, it outperformed the S&P 500 by over 5%. Meanwhile, in active risk terms, you only spent 50 basis points in tracking error. So as a manager, you know it’s only coming from stock selection – we’re confident it’s not factors or sectors in disguise. That’s a really exciting opportunity for us, to get that kind of outperformance and risk-adjusted performance, and to do it in a pretty compelling manner. That’s why you’ll see it’s such a large weighting in our model overall. I’d add that when people look at the weighting, they might be taken aback by it, but when you do think about the exposure itself, it’s by and large very similar to the large-cap index that serves as our benchmark. It just gives us what we think is a very significant performance advantage and a risk advantage – which, as portfolio managers, we obviously look for.
This Fallen Angels ETF also stands out as an interesting holding. What led you to add that one? What we see from the credit markets overall, with spreads where they are, is that there’s very little compensation available in investment-grade bonds at the moment. In the high yield space, you’re getting a little bit more spread, but your spread duration starts to really pick up there, for what you’re actually getting. In the ‘fallen angel’ space, what’s interesting is that you can get a very unique blend of both, because, obviously, you’re looking at the bonds of companies that have recently been downgraded from investment grade. So, you have a huge slew of bonds that were downgraded that are now upgrade-eligible and starting to come through into that cycle of improvement. We think that’s when fallen angels make a large amount of their returns.
Tell us about these sector holdings in energy and technology. This is a tactical bet that we have on energy prices on the reopening or the restart of the economy. Margins are going to stay fairly strong because of the cost discipline that they had to exercise in the downturn, and the balance sheet is going to improve because the oil price itself is getting higher. So we think that the reopening is going to drive demand while supplies are going to be constrained relative to demand in the short term, and that forms our tactical view on energy as a sector. The global tech position that we have is actually a strategic one. We first put it into the portfolio in 2018. We’ve done a lot of research on the long-run drivers of sectors and sector outperformance. In 2018, we saw an opportunity with a sector that had really, really strong cashflow. So very quickly, the discretionary ability to generate cash and use that cash in the business is really, really high in the sector overall. Additionally, the debt profile was very favorable, and there wasn’t a lot of leverage in this. On top of that, its revenue generation was consistently high. And in terms of valuation, the price you’re paying for that revenue generation was cheaper than the market, overall. So that combination of factors, if you stack it against the sectors, tech comes out on top. We’ve kept it in the portfolio since that time, even as it’s gotten more expensive. Certainly, it’s not looking at the same price-to-sales that it was in 2018 or 2019. But what we are getting from this position is the quality earnings, and that’s something that we want in the portfolio, especially as we think about what we might see in the bond market. In fact, we’ve got sector positioning that’s almost barbelled across what would happen if the 10-year yield moves up or moves down, and we’ve kept that positioning in place. The 10-year yield in 2021 has really been the driver of what your asset performance looks like, so we want to give ourselves a little bit of symmetry respective to moves in the 10-year yield. Let’s talk about rebalancing. We actually just rebalanced these portfolios on October 21, which was a little bit later than normal. But in 2020, which remains unbeaten for things that could go wrong and will go wrong, we rebalanced a total of six times over the year. That’s at the upper limit of what we like to rebalance the portfolio in that time horizon. Our next scheduled one is going to be at the start of 2022, but as and where we see a risk event developing or an event developing that we think isn’t priced into markets – and we think that there’s a real opportunity to add value as a discretionary active portfolio manager – we’ll take that opportunity. Was the October re-weighting event-driven? No, but we pushed it back a week from where we’d originally planned it, just because we were seeing some dynamics play out in the rates market and we wanted to let them run their course a little bit before thinking about what our final asset allocation looked like. I think if you take anything away from it, it’s just a dynamic process. It is run by active managers; we are looking at what the market is doing, rather than running this in a vacuum and reweighting just blindly.
Henry Orvin Senior Vice President Mondrian Investment Partners
Brian Ahrens, head of PGIM Investments’ Strategic Investment Research Group, explains how the firm’s strategic model portfolios optimize the best-in-class offering from PGIM’s affiliates.
A recipe for model portfolio success: delivering returns that clients deserve
Brian Ahrens
What are advisors (and their clients) looking for in models? What attributes are most important? Broadly speaking, there are core elements to a good model portfolio. The first is best-in-class funds. I have provided manager research and portfolio construction services for 20-plus years and what I have learned in that time is that not all firms are good at everything. So, you want to invest in a strategy that includes some proprietary and non-proprietary models which reflect the strengths of an organization. The second is the blending of active and passive. We don’t think portfolios should be completely active or passive: They should optimally blend the virtues of both. Finally, low investment minimums are important, as well as good performance. The combination of all of these factors can create a portfolio which has the potential to perform well. How do models improve outcomes for clients? Models provide diversification and lower costs in a customized way, as they are based on the client’s risk tolerances. If you can implement that in a simple, easy-to-understand, yet powerful investment approach that informs clients, it can create positive outcomes. Over the years, I’ve seen complicated processes that have yielded very little in incremental return. Oftentimes, when you build portfolios in line with long-held principles, supported by academic and empirical evidence, it delivers very good investment results. How do models help advisors with their business? The model business provides advisors with a great opportunity to outsource portfolio construction to a dedicated team. For example, our team within PGIM Investments is 100% focused on the management of models. We are dedicated to uncovering strategies and developing the right strategic allocation as well as the tactical tilts that yield the return that advisors expect for their clients. It’s a classic outsourcing model which allows advisors to scale up their business by devoting more time to attracting new clients. At the same time, there is flexibility available to advisors in terms of implementation and customization can be achieved. How are asset allocation decisions made for the PGIM Investments models? PGIM has a number of affiliates which focus on different parts of the market. We have Jennison Associates for equity, PGIM Real Estate, PGIM Fixed Income, and PGIM Quantitative Solutions (formerly QMA), which focuses on asset allocation and quantitative solutions. Finally, my organization – the Strategic Investment Research Group (SIRG) – oversees manager research and portfolio construction. PGIM Quantitative Solutions is responsible for tactical and strategic asset allocation for our models. They focus on performance and volatility expectations and translate this into strategic and tactical tilts. In addition to this, we take inputs from all of our affiliates to create well-diversified portfolios. How important is dynamic or tactical allocation to the model portfolio investment process? It is a core element to delivering excess returns. Without it, your portfolio falls short in terms of what it can possibly do. Tactical allocation can generate higher risk-adjusted returns, and allows you to take advantage of market opportunities, achieve diversification, and mitigate short-term risks in the market. The benefits are there, but it is important to take a measured approach to tactical exposures across sub-asset classes on a risk-adjusted basis. This matters tremendously to the success that tactical or dynamic allocations can bring to a portfolio. How are funds selected to fulfil asset allocation decisions? Our team has been overseeing and selecting investment managers for more than 20 years. The average tenure in our organization is 15 years. From our own experience, as well as academic studies, there are fundamental criteria that we believe a very good investment manager should have: things like long tenure, a strong track record, and investments in their own funds. There are other factors that we find quantitatively to be true. The first is our “performance hit rate” for funds that have outperformed their peers or their index more than 60% or 70% of the time. It is a measure of consistency and a very good indicator of success versus the one-off home runs that some funds experience. Funds that persistently outperform do very well over time. We look at this, alongside other criteria, to identify best-in-class funds. We’re never going to include a fund in one of our models which has a short track record or a brand-new manager, as we believe that experience matters. At the same time, we include passive funds to gain market beta cheaply, which perhaps we are not able to get from best-in-class managers. This also enables us to keep expenses relatively low. Some of our portfolios have between 20% and 40% in passive funds to achieve these aspects. What is it that sets PGIM’s model capabilities apart from the crowd? Firstly, we optimize the best-in-class offering from PGIM’s affiliates. There is a broad representation of very good actively managed portfolios that PGIM Fixed Income, Jennison, PGIM Quantitative Solutions, and PGIM Real Estate offer today. We take these strategies and incorporate them into our models. The second is active and passive. For us, it is not an either/or proposition. We have managed our models for almost three years and the results speak for themselves in terms of excellent benchmark and peer-relative performance through the blending of active and passive. The third is low minimums and the fourth is lower costs. Our goal is to keep expenses as low as possible because this means the client can keep more of the excess return that they deserve. That’s a very strong virtue that any portfolio should pursue.
head of PGIM Investments’ Strategic Investment Research Group
SIRG is a unit of PGIM Investments LLC, and a research unit of Prudential Financial. SIRG provides research, analysis, and due diligence on investment management firms and the vehicles and strategies they offer. Mutual fund investing involves risk. Some mutual funds have more risk than others. The investment return and principal value will fluctuate, and an investor’s shares, when sold, may be worth more or less than the original cost. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. There is no guarantee a Fund’s objectives will be achieved. The risks associated with each fund are explained more fully in each fund’s respective prospectus. Consult with your attorney, accountant, and/or tax professional for advice concerning your particular situation. Jennison Associates and PGIM, Inc. (PGIM) are registered investment advisors and Prudential Financial companies. PGIM Quantitative Solutions is the primary business name of PGIM Quantitative Solutions LLC. PGIM Fixed Income and PGIM Real Estate are units of PGIM. ©2021 Prudential Financial, Inc. and its related entities. Jennison Associates, Jennison, PGIM Real Estate, PGIM, and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide. This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional. 1053838-00001-00
It’s been nearly two years since Ben Hockema hung up his own shingle. In January 2020, he departed the Chicago-area office of RIA Deerfield Financial Advisors – where he had worked since graduating from Purdue University in 2010 – to found his own practice, Illuminate Wealth Management. With backing from mentor Gary Bowyer and best friend David Shirley, Hockema has grown his Chicago-based RIA into a $65m practice that works with 40 clients. The XY Planning Network member walked Citywire through one of his core model portfolios, which adds an inflation-protective twist to an equity-heavy allocation.
What is your approach to portfolio construction, and what’s the goal of this particular portfolio? The way we approach investing in general is to start with the global market Vanguard portfolio and then make changes and tweaks to that – whether that’s adding other funds that are tilted towards small caps or high profitability, changing between countries, or other things like that. When it comes to where this model fits in, this is similar to what we provide to a lot of our newer clients, the younger clients that we have in their 30s and 40s. It has moderate risk for them, since they invest for the long run. The way that we approach investing takes a long-term focus. The longer you’re invested, the less money in bonds you should have and the riskier bonds become. So given that a lot of our clients are in their 30s and 40s, it fits well for them. What led you to go with DFA for your core equity positions in this portfolio? It was the tax efficiency that DFA provides. We want to produce higher expected returns over the long run. So we allocate towards value, small-cap, and higher profitability equities. The other thing I would add – and there’s been some stuff in the press about this recently – is just the extent to which some funds float away from their targets.. So, most US core funds, even from Vanguard, have a lot of international exposure, or more than you would expect given the name. Dimensional is really good at saying that when it’s a US core ETF, it’s strictly US core. That’s why we have to add a separate allocation to REITs – they’re explicitly excluding them within the DFA funds. But the DFA funds still maintain the low cost, low turnover, and high tax efficiency that you would expect from a more passive investment. Your overall international equities exposure is higher than what others might go with. If you just look at global market capitalization – and these numbers are as of the end of 2020 – 57% is the US, 29% is developed international markets, and 14% is emerging markets. So since we start with a global market cap portfolio, the only reason that an advisor, in our opinion, should tweak that allocation between US and international equities is if they have strong opinions that one’s going to outperform another. There are compelling cases for tweaking allocations one way or the other. Meb Faber has done a lot of great work on saying international equities are undervalued right now. On the flip side, you have situations like from 2018, when Spotify – a European company – goes public, and it’s US-listed. It shows up in the US equity allocation. So with that, we say we want to be agnostic on location. Just because a company happens to be in Europe versus the US shouldn’t make us change our allocation to it, and that’s why we end up with a market-cap-weighted exposure.
Between the gold and the Treasury Inflation-Protected Securities (Tips), this portfolio seems to be built with inflation protection in mind. We see two main risks around inflation. You need the short-term principal-protection risk. That’s primarily going to be your bonds protecting against unexpected withdrawal needs, things like that. But the longer you’re invested, the more inflation matters and the less volatility matters. If in the long run, we’re going to make money in stocks – and we believe that, over decades, you will – then the number one thing we need to do is retain purchasing power for the clients. That’s why we have dedicated inflation protection in the portfolio. Do you believe gold is a good inflation hedge? And why did you go with the Sprott Physical Gold Trust, rather than the more popular SPDR Gold Trust ETF (GLD)? Well, the thought process is that for 5,000 years, gold has been a good inflation hedge. We would be interested in other things as a potential inflation hedge as well, even going so far as crypto. In terms of the ETF, we are definitely looking for true gold exposure, instead of something with counterparty risk because of derivative contracts or things like that. Sprott has this system so that if you wanted, you can actually turn in your shares and receive gold in exchange for your shares of the trust. Although we hope to never do that, the fact is that the gold is housed outside the US. That’s how we look at it: the ETF is for inflation insurance and also just financial market insurance. We want something outside the US since most of everything else is in the US. And also, we want something where we could actually get a physical commodity and not have to rely on some financial instrument.
How has your approach to investing changed over your career? One is that we were even more small-cap- and value-tilted before. When DFA came out with their profitability funds, we compared what we had and didn’t make any changes right away. The more we looked at it, the more we said – not that we think the value is dead – but that there are structural changes to the market from 80 years ago to today and maybe we should take into account some other factors than just a huge value tilt or a big small-cap tilt. For instance, a lot of small companies stay private longer and they become public as mid-cap or large-cap stocks. So by just investing in small-cap equities, you may be missing out on something, and maybe that small-cap premium isn’t as big as it used to be. Are you considering making any big changes to this portfolio? Nothing that jumps out that we’re doing. We are reducing the Tips exposure a little bit, but otherwise, no other major changes to the portfolio itself. We’re continuing to look for things like private equity for select clients, and then also, we’re adding SMAs and ESG-focused SMAs for certain clients that are really focused on that. That’s something that I think everyone in the industry is looking at: What do we do to serve clients that really want to have an ESG tilt?
Evolved Portfolios for Evolved Investor and Advisor Needs
Justin Blesy
In their ongoing search for yield, advisors and their clients seem to be fighting their way through a perfect storm as persistently low rates and tight spreads make it difficult to generate income responsibly. And, rather than bringing calmer waters, the prospect of higher rates from the Fed’s impending tightening cycle has many advisors concerned about their clients’ fixed income allocations. These challenges are exacerbated by the fact that many advisors have to navigate this difficult environment at a time when they’re also being asked to provide a broader suite of services to their existing clients and find new client relationships to grow their business. While this perfect storm may seem daunting for advisors, both asset managers and intermediary platforms are taking important steps to support them as they work to help their clients reach their long-term goals – often with the help of model portfolios that take an outcome-oriented approach. The Rise, and Evolution, of Model Portfolios Many advisors have revamped their business models to broaden their value proposition and focus more on holistic financial planning services, and so too have the support systems offered to them. Specifically, we see three developing trends that are meaningfully changing the landscape and broadening the tool kit advisors have at their disposal: - Home offices have either invested in improving their in-house technology or partnered with third-party platforms to provide more flexible unified managed account (UMA) platforms. - Both home office and asset managers are recognizing the importance of helping advisors transition to a models-based practice, and supporting the conversation that advisors are having with their clients by creating practice management content and simplified marketing collateral. - Asset managers have ramped up product development efforts, placing a greater emphasis on launching more outcome-oriented models that can complement traditional risk-based multi-asset portfolios. As a result, model portfolios have evolved from an “all-or nothing” concept to a resource that advisors can flexibly use to address a variety of specific client needs while still retaining the level of discretion that’s most appropriate for their practice.
Asset Allocation Strategist PIMCO
PIMCO Model allocations are licensed or otherwise made available to investment professionals. All investments contain risk and may lose value. PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. It is not possible to invest directly in an unmanaged index. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2021, PIMCO For financial professionals: The implementation of, or reliance on, a model portfolio allocation is left to your discretion. PIMCO is not responsible for determining the securities to be purchased, held and sold for a client’s account(s), nor is PIMCO responsible for determining the suitability or appropriateness of a model portfolio allocation or any securities included therein for any of your clients. PIMCO does not place trade orders for any of your clients’ account(s). Information and other marketing materials provided to you by PIMCO concerning a model portfolio allocation -including holdings, performance and other characteristics may not be indicative of a client’s actual experience from an account managed in accordance with the model portfolio allocation. CMR2021-1103-1904893
Mark Thomas
Head of SMAs and Models PIMCO
RYAN McMAHON
Account Manager PIMCO
“The low yields and tight spreads that we’re currently experiencing cannot be solved with plain vanilla approaches – and stepping further out on the risk spectrum for income can derail a client’s long-term goals”
Evolved Fixed Income Model Portfolios in Action Flexibility and a broad toolkit is arguably most needed in fixed income. “The low yields and tight spreads that we’re currently experiencing cannot be solved with plain vanilla approaches – and stepping further out on the risk spectrum for income can derail a client’s long-term goals,” said Mark Thomas, PIMCO’s head of SMAs and models for the wealth management team in the U.S. “It’s important to remember that a bond sleeve can serve a number of different objectives, ranging from capital preservation to income generation, so having a diverse mix of potential building blocks is essential for advisors to address unique client needs.” Fortunately, the evolution of outcome-oriented model portfolios is helping advisors implement fixed income models in a wide variety of ways across their practice, including: - Using conservative, capital preservation-oriented fixed income models to move cash off of the sidelines and increase clients’ return potential while still minimizing risk and drawdown potential. - Leveraging higher-quality core fixed income models to diversify clients’ equity exposure (either equity models or self-managed portfolios of equity ETFs/individual stocks). - Using income-focused models to replace the income stream of maturing bonds and keep clients well-diversified across sectors and geographies. While outcome-oriented model portfolios may arm advisors with greater optionality, they may still be hesitant to give up discretion. However, advisors wishing to maintain discretion can still benefit from model portfolios. For example, models can be used as a tool to help visualize a firm’s investment outlook and provide prescriptive guidance on the number of line items and position-sizing in certain strategies across different client objectives. In other words, rather than simply listing potential ingredients, asset manager models now detail the suggested recipe for seeking specific outcomes. Discretion-maintaining advisors can use these “paper portfolios” as an input in their own portfolio construction processes. Whether directly leveraging models as an investment solution or simply using paper portfolios to help make more informed investment decisions, the evolved models landscape can support advisors in a variety of ways as they help address their clients’ needs and meet their long-term financial goals.
To learn more, visit pimco.com/exploremodels
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Liability To the maximum extent permitted by law, Citywire will not be liable in contract, tort (including negligence) or otherwise for any liability, damage or loss (whether indirect, consequential, special or otherwise) incurred or suffered by you or any third party in connection with our Site, or in connection with the use, inability to use, or results of the use of our Site or App, any websites linked to it or any materials posted on it or otherwise in relation to any Content or Feed. Citywire does not limit liability for fraudulent misrepresentation or for death or personal injury arising from Citywire’s gross negligence or willful misconduct. HOWEVER, YOUR EXCLUSIVE REMEDY FOR ANY CLAIM ARISING FROM A BREACH BY CITYWIRE OF THESE TERMS IS CESSATION OF USE OF THE SITE, APP, OR CONTENT. FURTHER, TO THE GREATEST EXTENT PERMITTED BY LAW, THE TOTAL LIABILITY OF CITYWIRE IS LIMITED TO THE GREATER OF $50 OR AN AMOUNT NOT EXCEEDING THE TOTAL AMOUNT ACTUALLY PAID BY YOU TO CITYWIRE DURING THE PRIOR SIX (6) MONTHS IN CONNECTION WITH YOUR INDIVIDUAL USE OF THE SITE OR THE APP. In addition, you may bring a claim only on your own behalf. You will not participate in a class action or class-wide arbitration for any claims covered by these terms. 12. Changes to our Terms Citywire may change the Terms from time to time. Any such changes will be incorporated on our Site. Changes will take effect 30 days after notification. Your continued use of any part of the Site following such change shall be deemed to be your acceptance of such amended Terms. You acknowledge that you are solely responsible for checking these Terms from time to time to see the changes which have been made to these Terms. If you do not accept any such changes you should stop using our Site. 13. Breaches; Term and Termination 13.1 The Terms will take (re-take) effect at the time you access and use the Site. You agree that Citywire may terminate your membership or the agreement constituted by these Terms (as Citywire may choose) and restrict your access to the Site (or part thereof) without prejudice to any other rights or remedies that Citywire may have if Citywire is of the reasonable opinion that you have breached these Terms or acted inconsistently with the spirit of these Terms. The provisions concerning Intellectual Property Rights, The Site, Contributions, Non-Reliance, Limited Warranty, Liability, Breaches; Term and Termination, Enforcing Security, Governing Law, Arbitration, Injunctive Relief, Waiver and Severability and Entire Agreement the Solution Feedback, Confidentiality, will survive the termination of these Terms and Conditions for any reason. 13.2 You agree to indemnify Citywire against any and all actions, claims, costs, proceedings, losses, damages or liabilities arising from your use of the Site or App (including without limitation Contributions or Content) and/or in relation to any information or data you use or access by means of the Site. 13.3 You acknowledge that a breach of these Terms may give rise to civil damages and criminal penalties. Citywire reserve the right to take action against you to uphold these Terms and its rights, which may involve pursuing injunctive proceedings, as further set forth below. 14. Enforcing Security You may not use the Site, App, Content or any of Citywire’s data, systems, network, or services to engage in, foster, or promote illegal, abusive, or irresponsible behavior, including, without limitation, accessing or using data, systems, or networks in an unauthorized manner, attempting to probe, scan, or test the vulnerability of a Citywire system or network, circumventing any Citywire security or authentication measures, monitoring Citywire data or traffic, interfering with any Citywire services, collecting or using from the Site email addresses, screen names, or other identifiers, collecting or using from the Site information without the consent of the owner or licensor, using any false, misleading, or deceptive TCP-IP packet header information, using the Site to distribute software or tools that gather information, distributing advertisements, or engaging in conduct that it likely to result in retaliation against Citywire or its data, systems, or network. Actual or attempted unauthorized use of the Site may result in criminal and/or civil prosecution, including, without limitation, punishment under the Computer Fraud and Abuse Act of 1986 under U.S. federal law. Citywire reserves the right to view, monitor, and record activity through the Site without notice or permission from you. Any information obtained by monitoring, reviewing, or recording is subject to review by law enforcement organizations in connection with investigation or prosecution of possible criminal or unlawful activity through the Site as well as to disclosures required by or under applicable law or related government agency actions. Citywire will also comply with all court orders or subpoenas involving requests for such information. In addition to the foregoing, Citywire reserves the right to, at any time and without notice, modify, update, suspend, terminate, or interrupt operation of or access to the Site, or any portion of the Site in order to protect Citywire. 15. Governing Law; Void Where Prohibited All offers for all functions, products or services, which are made on the Site, are void if they are prohibited by applicable law. You access the Site on your own volition and are responsible for compliance with all applicable laws with respect to your own access and use of the Site and its offerings. These Terms have been made in and will be construed and enforced in accordance with the laws of the State of New York, U.S.A. as applied to agreements entered into and completely performed in the State of New York (without effect to its conflicts of law provisions). 16. Arbitration Subject to the right of Citywire to seek injunctive relief, disputes will be will be resolved by binding, individual arbitration under the American Arbitration Association pursuant to its Commercial Arbitration Rules or pursuant to its International Centre for Dispute Resolution (ICDR) Rules, and judgment on the award rendered by the arbitrator(s) may be entered in any court having competent jurisdiction thereof. There is no judge or jury in arbitration, and court review of an arbitration award is limited. For any arbitration, the arbitrator(s) selected shall have a minimum of ten years of experience with and knowledge of the subject matter of the claim and dispute. The place of arbitration shall be in New York, New York. The arbitrator shall be bound by the provisions of these Terms and base the award on applicable law and judicial precedent. The arbitrator may award money or equitable relief in favor of only the individual party seeking relief and only to the extent necessary to provide relief warranted by that party’s individual claim. Similarly, an arbitration award and any judgment confirming it apply only to that specific case; it cannot be used in any other case except to enforce the award itself. However, the arbitrator(s) may award to the prevailing party all of its costs and fees. “Costs and fees” mean all reasonable pre-award expenses of the arbitration, including the arbitrator’s fees, administrative fees, travel expenses, out-of-pocket expenses such as copying and telephone, court costs, witness fees, and attorneys’ fees. Upon rendering a decision, the arbitrator(s) shall state in writing the basis for the decision, including the findings of fact and conclusions of law upon which the decision is based. The decision of the arbitrator(s) shall be final and binding upon the parties, and shall not be subject to appeal. You and Citywire have agreed to execute this Agreement in the English language, and all dispute settlement proceedings and communications, written and oral, between you and Citywire shall be conducted in the English language. 17. Injunctive Relief Notwithstanding the arbitration provision above, you acknowledge that any breach, threatened or actual, of these Terms, including, without limitation, with respect to unauthorized use of Citywire’s proprietary assets and especially, any Content, will cause irreparable injury to Citywire. Such injury would not be quantifiable in monetary damages and Citywire would not have an adequate remedy at law. You therefore agree that Citywire shall be entitled, in addition to other available remedies, to seek and be awarded an injunction or other appropriate equitable relief from a court of competent jurisdiction restraining any breach, threatened or actual, of your obligations under any provision of this Terms. Accordingly, you hereby waive any requirement that Citywire post any bond or other security in the event any injunctive or equitable relief is sought by or awarded to Citywire to enforce any provision of these Terms. 18. Waiver and Severability Failure to insist on strict performance of any of the terms and conditions of these Terms will not operate as a waiver of any subsequent default or failure of performance. No waiver by Citywire of any right under these Terms will be deemed to be either a waiver of any other right or provision or a waiver of that same right or provision at any other time. If any part of these Terms are determined to be invalid or unenforceable pursuant to applicable law including, but not limited to, the warranty disclaimers and the liability limitations set forth above, then the invalid or unenforceable provision will be deemed superseded by a valid, enforceable provision that most clearly matches the intent of the original provision and the remainder of these Terms shall continue in effect. 19. Notice; Consent to Electronic Communications When you visit this Site or send e-mails to us, you are communicating with us electronically. You consent to receive communications from us electronically. We will communicate with you by e-mail or by posting notices on this Site. You agree that all agreements, notices, disclosures and other communications that we provide to you electronically satisfy any legal requirement that such communications be in writing. 20. Entire Agreement You and Citywire are independent contractors. No joint venture, partnership, employment, or agency relationship exists between you and Citywire as a result of these Terms or your utilization of the Site. These Terms represents the entire agreement between you and Citywire with respect to your individual use of the Site. These Terms may not be assigned, transferred, conveyed, delegated, or granted by you to another party or person without the prior written consent of Citywire.
