Episode 20 – The Problem with “Model Portfolios”

Welcome to Market Perspectives, a Mercer Advisors podcast. For today’s episode, we’re going to talk about model portfolios. And specifically, we’re going to talk about why we don’t really like that phrase “model portfolio,” why we think you can do a lot better than a model portfolio when you’re investing. I’m Josh Zumbrun. I’m the director of External Communications at Mercer Advisors. I’m joined today by Don Calcagni, our chief investment officer. Don, thanks so much for being here.

Josh, it’s great to be here. Thank you.

So, Don, a lot of our listeners have probably come across this phrase model portfolio but may never have heard it defined, and some people may never have heard it at all. So it’s a common phrase in the wealth management industry. But how would you define the term the way that people use it and the way we ought to be thinking about it for this discussion?

Well, Josh, I mean, first off, you’re right. This is a term that is used broadly throughout the asset management industry. And to be fair, I think it means different things to different people. It depends on whom you’re speaking to and whether or not you’re an asset manager or whether or not you’re a client or an advisor.

Generally speaking, a model portfolio is a portfolio where the holdings, the specific tickers, whether those be stocks or ETFs or mutual funds, where the tickers are defined. They’re set. They’re unchanging. They’re sort of etched in stone, so to speak. So both the tickers and the weights of the portfolio that are allocated to those tickers are etched in stone.

So it’s unchanging. It’s a model. It’s a framework that says, here’s what we’re going to own, and these are the weights in which we are going to own these different things. And generally, it’s interpreted to be something that’s very unchanging, very consistent, something that’s very easy to report on, something that’s very easy to show backtested or perhaps even actual performance on the model portfolio because it’s a known quantity. It’s a known entity that is unchanging by definition.

And that’s also part of what people don’t like about it, I guess, that it’s a very cookie cutter approach.

Correct, Josh. On the one hand, the good thing about a model portfolio for a lot of advisory firms is that it’s very scalable. It’s very easy to set up in your portfolio management system. I think from a client perspective, what’s attractive about a model portfolio is that it’s very easy to report on. If you want to see, for example, well, what are the historical returns on the model portfolio? well, that’s very easy to share with clients and prospects.

But I think, generally speaking, it’s viewed as a negative. If I’m an investor, I want something that’s truly customized that speaks to my unique situation. I want something that takes into account my personal preferences, whether that be my preference for ETFs or individual securities, perhaps my preference to invest only in US securities, and perhaps to avoid non-US securities.

I think, in today’s world, given all the choices that we have as customers, as clients, we want more choice. We want something that’s truly custom tailored to our unique financial situation.

So I think I better understand the limitations of a model portfolio. Probably be helpful to contrast it to what we think a better approach would be. So we talk about investment programs. What is meant by that phrase?

An investment program is an investment strategy that is truly personalized to your unique situation and is deeply integrated with a broader approach to managing entire balance sheet. If you think of your financial situation, your financial picture includes more than just your brokerage account or your IRA. It includes perhaps real estate. It’s your home. It’s your debt. It could even be your credit card debt. It could be your tax situation, the income tax bracket that you’re in.

There’s a lot that goes into building an investment program that is deeply integrated with your broader balance sheet. And that’s exactly what an investment program does, Josh, is it takes into account your personal constraints. Those constraints could be tax related. They could be legal. Perhaps you work for a publicly traded company, and you have equity in your employer.

Takes into account also your personal preferences. Maybe you want to own individual securities and not own ETFs or mutual funds. So an investment program takes into account constraints, your preferences, and then deeply integrates with your broader balance sheet to maximize the value of your balance sheet over time and through time, and not just focused on one particular investment account, or IRA.

Now, you recently had an interview with Citywire RIA. It was what prompted this whole discussion because they’re doing a series that they call “My Model Portfolio.” It’s the name of the series. And so you talk to them about the multifactor, all-weather investment program that Mercer Advisors has, even though we don’t like that phrase model portfolio.

But let’s take a second here to walk through what that program means because then this is a helpful example that shows how it ends up being very different from what a model portfolio might do.

So, Josh, if we think about what our multifactor, all-weather portfolio is doing is it’s diversifying broadly across US and non-US public markets, meaning publicly traded stocks, publicly traded bonds, publicly traded real estate, but also private markets. It’s allocating across private equity, private credit, perhaps private real estate. And if you think about what we’re doing there, we’re using the institutional buying power of Mercer Advisors, want to access those asset classes. These are asset classes that most investors candidly cannot access at a very low price point or very efficiently on their own.

So we’re using our institutional buying power to access these asset classes. But then we’re actually taking that program, and we’re actually tailoring it to speak to clients unique constraints and preferences. A client can actually take that program and fund it. And I know we’re going to talk about funding here in a moment.

But they can actually fund it with a combination of cash or even existing securities, legacy securities. Maybe they already have a basket of individual stocks or ETFs. On the private investment side, we can actually build a custom tailored investment program for ultra high net worth families that seeks to invest in private equity. Could be venture capital. Could be middle market growth equity. It could be private credit. So there’s a lot of things we can do there to really custom-tailor that portfolio for the family.

And I think two takeaways from that. I mean, one is that’d be very hard to do with a cookie cutter sort of approach. And two is that it’d be very, very hard for a DIY investor to accomplish all these things on their own.

Correct. There’s no such thing as a model portfolio, Josh, that invests in true private equity or true private real estate or venture capital. That’s just not a thing. There’s some products out there in the marketplace that are trying to do that. Our view is they’re actually not very good at the moment.

But you’re right. There’s no model portfolio that does these things. And then with respect to accessing private markets, candidly, that’s something that’s very difficult for most individual investors to do on their or, certainly to do on their own to do it very well.

Even very wealthy investors, it’s hard.

That is correct. I mean, the very best private equity funds in the marketplace, it’s not uncommon for them to have minimums of 5, 10 or even 20 or $25 million per investor. And those are naturally prohibitive for most mere mortals.

So, Don, give us a little bit more color on what are some of the specific things that are done here to customize this, that makes it very different from a model portfolio approach.

There’s a range of items that really separate an investment program from a model portfolio. So let me just give you a couple of examples. Typically with a model portfolio, you need to fund that with fresh cash. Like I said earlier when I was explaining what is a model portfolio, it has preset holdings, preset tickers.

Well, what happens if you have a taxable portfolio with low basis holdings? Well, for a true model portfolio, that means you have to sell those in order to fund the model portfolio. Well, an investment program has no such requirement. If you have the right technology, if you have some of the more sophisticated technology that’s out there in the space, you can actually take all of those legacy holdings and absorb them into the investment program.

You can set those as alternates for some of the tickers that you otherwise would have purchased in your investment program. So, for example, if you have an investment program that is trying to invest in the S&P 500 index but you already own an S&P 500 index ETF, or perhaps you already own an actively managed US large cap mutual fund that you’ve owned for many decades, we can actually take that and absorb that into the investment program. So that’s just one example.

Additionally, with an investment program, Josh, you can actually put in place a custom capital gains budget. When you’re managing a portfolio, one of the things we say at Mercer Advisors is that the only returns that matter are the ones that you get to keep. So carefully managing an investment program to account for capital gains to account for the client’s income tax bracket is critically important to making sure that we’re maximizing the value of the balance sheet and not just what’s happening inside of one particular investment account.

So we can set our trade logic. We can customize the trade logic for an investment program to account for very specific capital gains budgets. Perhaps a client is selling a family-held business. That is a very large capital gains event in most situations. So in many circumstances, many situations, we’ll actually set the capital gains budget to be zero for the taxable accounts that we’re managing for clients because they have these other things that are happening across their balance sheet.

To take it a few steps further, Josh, we have clients, for example, that love individual securities. They don’t want to own mutual funds or ETFs. Well, with an investment program, you can really custom-tailor the implementation of the investment program to focus on investing only in individual securities or perhaps only in US large cap equities. That’s typically where we see a lot of clients want to own individual securities, and maybe they’re fine with using ETFs to invest in emerging markets or something like that.

So you can really personalize the implementation not just of the public market side of the portfolio, by the way, Josh. We can also really personalize the private markets implementation. For example, we have clients that are more focused on generating income across their balance sheet. Maybe they’re transitioning into retirement.

Well, we can use private credit in the private markets space to really generate higher levels of income than what is generally available in the public markets. So we can really custom-tailor both the public and private market’s implementation of an investment program. And with a traditional model portfolio, that high degree of integration with the broader balance sheet, that customization, candidly, it’s just not possible with traditional model portfolios.

The point about capital gains is not a small point. I mean, I’ve heard you say this, and I love this, that when we talk about management fees, we sometimes focus on a basis points–

1/100 of a percentage point. We’ll say, oh, this is 0.08 instead of 0.09. Isn’t that great?

But when you talk about capital gains, you’re talking about thousands of basis points.

Correct.

A 25% tax is 2,500 basis points. It drives home, I think, how big the capital gains implications can be relative to some of the very small things. And it’s not to say that they don’t matter. We care a lot about fees, but you can miss a much bigger issue sometimes.

I say this all the time. It’s like tripping over dollars to pick up nickels. We measure investment fees in basis points, but we measure taxes in tens of percentage points. Maximum capital gains rate is 23.8%,

and that’s the long-term capital gains rate. The short-term capital gains rate, depending on your state and your situation, is easily over 40%. So, Josh, right there is 14% 16% easy that we could be capturing if we’re just paying attention to how we manage the capital gains in the portfolio.

And to take that capital gains hit to get into a model portfolio that maybe is going to do however much better, you might never make up that capital gains hit.

It’s absurd if you think about it. Let’s say you have a portfolio that’s maybe at 80-basis points, and a model portfolio has 40-basis points. Sure, you’re going to save 40-basis points in fees, but if you have to incur a 23.8% capital gains tax hit just to fund the model portfolio, your break even is decades. It’s going to take you a long time to recapture those capital gains taxes.

So, Don, let’s tie this all together and just give people the takeaways from this discussion about investment programs versus model portfolios.

Josh, I think there’s probably three broad takeaways that I would emphasize. Number one is that while there’s nothing inherently wrong with a model portfolio, it’s important to recognize that model portfolios by themselves can be quite limiting. So that’s number one is that model portfolios can be pretty limited.

Number two, Josh, is that investment program by definition is designed to be very liberating. It’s designed to maximize the value of our balance sheet over time. It takes into account all of the things that we’ve been discussing–

your constraints, your preferences, your capital gain situation, your broader tax situation. Whereas a model portfolio typically does not pay attention to any of those very important dimensions of your financial picture.

And then I think, third, when it comes to building a truly customized investment program, you really need three things. That is, one, you need a best-in-class technology, which, candidly, is not readily available in the marketplace for most firms and certainly not for most investors. Number two would be you really need deep expertise. You need to understand what is the tax treatment of everything that’s happening on your balance sheet.

How is your estate plan set up? And then how could your investment program really amplify all of those different attributes, those different dimensions of your balance sheet? And then finally, last but not least would be you really want to have that institutional buying power. We were talking about investment fees being measured in basis points versus taxes being measured in full percentage points.

But those basis points still matter, and it’s important to fight for every basis point and try to push those fees down as low as possible. That’s where that institutional muscle is really important to helping you really maximize the value of your balance sheet over time.

Don, thanks so much for being here today for this discussion.

Josh, it was great to be here. Thank you.

If you’re already a Mercer Advisors client and have questions about your investment program and how this all is working in your account, feel free to reach out to your advisor. It’s a great starting point for a discussion. If you’re not a Mercer Advisors client and you’re interested in more information or learning about what this approach might look like for you, check out our website, merceradvisors.com. Thank you so much for being with us today. This has been Market Perspectives.

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