The trillions of dollars in assets moving into model portfolios should come with a note of caution about ETF costs, returns and how they relate to conflicts of interest, a new study suggests.
Asset managers working with financial advisors in a “dual role” through their funds and model investment portfolios recommend affiliated ETFs more often than unaffiliated funds that have lower fees and better performance,
While the data comes from a preprinted academic paper that hasn’t received peer review and it doesn’t cover the models deployed by large brokerages and robo advisors, no planners expressed any surprise or disputed the findings. The models help advisors reduce the amount of time
The results cast doubt on “the ‘free’ model portfolios [asset managers] so generously hand out to FAs,” advisor Kashif Ahmed of Bedford, Massachusetts-based American Private Wealth said in an email.
Advisors “should not wash their hands of investment management and focus on the planning part just because this is the ongoing narrative being pushed on them. That push has an ulterior motive, as this study has uncovered,” Ahmed said. “Simply grabbing a free model and walking away from it assuming, ‘It is in good hands’ is a disservice to clients. A little cynicism would be warranted and beneficial here.”
The findings
The study by business and finance professors Jonathan Brogaard of the Utah School of Business, Nataliya Gerasimova of NHH and Ying Liu of Shanghai represents, “to the best of our knowledge,” the first one to track “asset managers’ and strategists’ model recommendations to financial advisors and relate them to the conflicts they face,” according to the paper. Though limited by the fact that model providers face fewer reporting requirements than fund managers as well as the differences in the available Form ADV disclosures about conflicts of interest, the results carry direct importance to advisors, Gerasimova said in an interview.
“They address it, but there's a huge heterogeneity about how they go into details,” Gerasimova said of asset managers’ disclosures. “The cost will be on the end investors.”
In terms of cost, affiliated ETFs used in asset managers’ models come with average expense ratios of 31.93 basis points, or 5.84 bps higher than those of unaffiliated ETFs, according to the study. Affiliated ETFs also “exhibit significantly worse past performance” than unaffiliated products, with year-to-date returns 67 bps lower. In the 12 months after being added to a model, the unaffiliated ETFs generated net returns that are 60 bps above peers, compared to affiliated ETFs that came in 47 bps below similar funds.
Other interesting findings include:
- The number of models soared to 886 different products in 2020 from only 37 in 2010. The amount of asset managers and other strategists offering them rose to 79 different firms in that span from just eight.
- The average number of ETFs in a model plummeted by 2.85, or 42%, to 3.99 in 2020, while the average number of affiliated ETFs in the portfolios rose to 1.40 from zero a decade earlier.
- As the average percentage of the models allocated to ETFs slipped by more than five percentage points to 29.44%, the average amount steered to affiliated ETFs grew to 11.96% from zero.
- The odds of an affiliated ETF being included in a model are more than three times as high as those of unaffiliated funds. When the expense ratio of affiliated ETFs increases by 1 bp, the likelihood it’ll be selected goes up 3%. When the cost of an unaffiliated ETF rises by 1 bp, the odds of its selection goes down 1%.
Advisors working in the industry for a long time and academics studying it over the past decade have gained familiarity with conflicts of interest. In the realm of “literature examining the recommendations of financial intermediaries,” the study cites earlier research finding that broker-sold funds have lower returns than directly purchased ones, mutual fund families show a bias toward their own products in 401(k) plans, and platforms favor affiliated fund products and the ones paying them commission, among other examples.
The reactions
One of the largest asset managers offering models, Morningstar Investment Management, didn’t respond to requests for comment on the study. Paige Hofman, a spokeswoman for BlackRock, emailed a statement.
“As a fiduciary, BlackRock provides model portfolios for advisors designed to meet clients’ investment objectives while controlling for risk in an efficient, cost-effective manner,” Hofman said. “Our platform offers advisors choice from a wide range of portfolio options which may include iShares ETFs, BlackRock mutual funds and ETFs and funds from third party managers.”
Large brokerages have the most assets in models,
Advisors managing more than two-thirds of the industry’s assets either customize their portfolios based on individual clients or build their own, according to Cerulli. Only those managing 7% of the assets use models from brokerages, fund managers, turnkey asset management programs or other firms without making any changes.
"Financial advisors need to look inside a model portfolio to understand the risk and reward traits of the underlying holdings,” Todd Rosenbluth, CFRA’s head of ETF and mutual fund research, said in an email. “While using an ETF filled with only products from one firm is easy, it is not always prudent."
Dexter, Michigan-based advisor Melissa Joy said in an email that she wasn’t surprised by the results of the study.
“When you remove competition and lean toward proprietary investments, price sensitivity may fall,” Joy said. “This is one of the reasons I’ve held onto the decision-making within an internal investment committee rather than outsourcing to a TAMP or model provider for my clients at Pearl Planning. This allows for competition and diversification between ETF providers and forces us, as fiduciaries, to consider costs in our reviews and decisions frequently.”
At Atlanta-based Rollins Financial Advisors, partner Robert Schultz’s team is going through the first steps of researching and creating potential model portfolios, he said in an email.
“We have noticed that some of the investments have not kept up with what we perceived to be adequate performance. As our industry has concluded that financial planning is of the utmost importance, it is also essential to note that the performance of the investments should not be forgotten,” Schultz said. “We are hoping that the models that we create will allow us the freedom to explore a deeper connection with our clients, which would include planning. However, it cannot be done in a vacuum where performance is not monitored.”
The models save practices time, but advisors only need to check what’s inside of them at the beginning or anytime they change their makeup “in order to provide what’s best for the client,” Scott Alan Turner, a freedom specialist with Hudson Oaks, Texas-based Rock Star Financial Planning, said in an email.
“It's a disservice to clients to recommend something without spending any amount of time figuring out what the makeup is. That's kinda like a nutritionist recommending pre-packaged food for improved health without reading the ingredients or understanding what those ingredients can do to someone's body,” Turner said. “It shouldn't be a concern if we're performing our due diligence to check the costs, performance and alternatives available. That's part of what being a CFP is about.”
Ahmed largely agreed with the other advisors, although he used a different analogy to describe the asset managers’ models.
“This should obviously be a source of concern for those FA's that tout being fiduciaries and their clients who are astute and engaged with the inner workings and composition of their portfolio,” Ahmed said. “I have never used any free models, especially from asset managers. It's akin to printer manufacturers practically giving away printers, but then raking it in from sale of toner. Be vigilant about that. I build my own models. And I stand behind them, underperformance and all.”
