John Kessell of Morningstar looks at the role, rationale and application of model portfolios, and explains some of the main considerations when using them.

Date: Jun 2011

Tags: Model portfolios, Investment horizon, Transparency

• Model portfolios can be an effective way to invest given that they are selections of stocks which are packaged together by an investment professional
• They tend to incur significantly lower costs than conventional funds, as well as being very transparent
• Investors need to have a high degree of confidence in the manager, since the returns still depend on the skill and judgement of that individual in selecting the stocks
• It is also important to understand the mandate of a model portfolio, including which securities which they can invest in, the behaviour of the manager, and how much cash they can hold

According to John Kessell in an interview, model portfolios can be an effective way to invest given that they are selections of stocks which are packaged together by an investment professional, and typically with someone watching the portfolio all the time.

They therefore allow investors to put money into a portfolio without needing any expertise or time to follow the stocks, or make any decisions about which ones should be added or removed depending on market events.

At the same time, added Kessell, model portfolios tend to incur significantly lower costs than conventional funds, as well as being very transparent, with investors and managers cable to clearly see all holdings with the ability to track them on a daily basis.

Using model portfolios for clients

Given that the primary focus for financial advisers is to know their clients, understand their risk tolerance and profiles, be aware of where they are in their lifecycle and whether they should be oriented to growth assets or getting towards the point where they are saving for retirement – Kessell said that advisers can look at using model portfolios as part of a core-satellite approach for their clients.

Model portfolios can be used for either purpose, depending on their composition, he explained.

In line with this, Kessell said time horizon is an important consideration. And at Morningstar, he explained, the firm takes a three- to five-year view on stocks given that they can often be mis-priced for long periods of time.

A common error that investors make, he said, especially in Asia, is having a very short-term investment horizon, because this affects the reliability of returns over a sustained period of time.

Investor considerations with model portfolios

According to Kessell, investors need to have a high degree of confidence in the manager of a model portfolio, since the returns still depend on the skill and judgement of that individual in selecting the stocks for the fund.

As a result, investors should review the background and credentials of the manager, he said.

It is also important to understand the mandate of a model portfolio, added Kessell. These vary greatly in terms of the range of securities which they can invest in, as well as the behaviour of the manager, he explained. For example, whether they would use leverage or some form of derivatives.

How much cash they can hold is another factor to look at. For instance, in some model portfolios, managers have a lot of scope to choose which sectors they can invest in or the percentage they can invest in any single security. Investors might also want the manager to have the flexibility to move more heavily into cash when dark clouds loom; or they might want the manager to always stay invested and leave the cash-allocation decisions up to the individual investor.