How precise is your professionally-managed model?

January 23, 2018 Categories: Portfolio Corner
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Dartboard with arrows near center, signifying precision of model strategies
Are your models missing something?

Building model strategies—investment portfolios that target and solve for specific client objectives—is hard work. We’d know. At Russell Investments, we’ve been doing just that for over 25 years. Along the way, we’ve learned the importance and performance-driving potential of strategic asset allocation. That long-term asset allocation is intended to be about big levers and thoughtful moves, and rightly so. But, we believe model portfolios also need speed and precision. They need the ability to make precise tweaks to the overall portfolio that reflect ever-changing capital markets. Doing so may allow models to capitalize on valuations and volatility while potentially better positioning investors to stay invested and focused on long-term goals.

Precision matters

For many model providers, the instruments for adjusting model strategies are often blunt and untimely, which can potentially lead to clumsy execution, as many models tend to be simple collections of mutual funds or ETFs which trade on a pre-determined schedule. Typically, model builders make annual changes to portfolios by simply swapping out one ETF or mutual fund for another. But simply combining funds can often create unintentional gaps and overlaps, not to mention generate transaction costs for investors.

What about more precise tilts to portfolios, like adding exposure to a factor, like momentum, when investor sentiment is high? What about underweighting an interest-rate-sensitive industry to account for the expectations for higher rates? Or temporarily dialing down exposure to a currency around an uncertain political election?

Without specialized capabilities, executing specific, nuanced positioning changes within a model becomes difficult, if not impossible. That’s why we believe the best model providers focus intently on developing strategies and capabilities that can help make precise, tactical changes in real time. We call this dynamic portfolio management. And we think advisors should demand it from their model-providing partners.

Here’s an analogy: Remember the old 1960’s board game, Operation, where one shaky move ended your turn with the jolting sound of a buzzer? Now imagine playing Operation with oven mitts on. The resulting lack of fine motor skills would leave your red-nosed patient in a perilous position. So why do it?  Models work the same way. Why choose imprecise, slow-moving model portfolios, when best-practice model providers offer speed and precision? Why not take off the oven mitts?

Beyond strategic asset allocation

We believe the best models use the strategic and the tactical. But again, we believe the tactical is only meaningful with precise, dynamic portfolio management. And for us, dynamic means managing right at the moment when opportunities or risks are present and actionable, not once per year.

When it comes to building models, precision can be added by focusing on the following best practices.

  1. Incorporation of near-term market views.
    • Most strategic asset allocations are changed on an annual schedule. But markets move more frequently, so model positioning should have the flexibility to adjust.
  2. Use of an open-architecture investment process.
    • An open-architecture investment process allows model builders to source expertise from multiple firms, which means clients can benefit from specialist opportunities that come and go over a market cycle.
  3. Efficient trading to ensure precise portfolio positioning.
    • Does your provider have daily transparency into each position in the model? If they do, and can combine this with an in-house trading capability, this can allow portfolio managers to dial-in more exact portfolio positions.

Now what?

When it comes to models, what’s an advisor to do? My strong opinion is that savvy advisors should select a model manager, not build their models from scratch. Why? As I discussed in a previous blog post, models can help free advisors from the burden of building portfolios from scratch. Custom portfolio construction takes time away from the primary value advisors provide: filling the vital role of behavioral finance coach, handling complex and challenging wealth management opportunities, while continually guiding clients with a holistic view of their financial lives.

When choosing model strategies for your investors, be sure you’re doing more than just outsourcing the core stuff—the strategic asset allocation. The models you choose should offer much more. They should offer truly dynamic tactical adjustments and a level of precision that works to gather in more upside opportunities and minimize uncompensated risks.

Disclosures:
These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

The Russell logo is a trademark and service mark of Russell Investments.

Copyright © Russell Investments Group, LLC 2018. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments.

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