Model portfolios traditionally have been built in accordance with the licensee’s strategic asset allocation (SAA) framework. In theory, the SAA framework provides an optimal mix of asset classes for selected risk profiles and the related long-term volatility targets.
Within each asset class, the model portfolios provide a blend of sector-specific managed funds that aim to meet one or both of the following objectives:
- Provide a higher return for each asset class than the passive index option, and/or
- Provide a lower volatility for each asset class than the passive index option.
Inherent in the rationale for blending active managers in asset “buckets” for model portfolios is a belief that there is a degree of predictability in the likelihood that an active manager will add value in terms of risk-adjusted returns. Additionally, it is believed there are diversification benefits in the appropriate blending of active managers with different styles.
Although we have no dispute with the underlying rationale for traditional model portfolios, in recent times there has been an increased demand from advisers for a different style of model portfolio, built with the aim of achieving specified objectives.
The most common example of an objective-based model is one designed to achieve a specified income level or income target range. Other objective-based approaches include the design of portfolios to meet the needs of clients in transition to retirement or clients seeking a specified overall rate of return on their portfolio.
With a range of objective-based approaches available, advisers are able to demonstrate that a chosen portfolio meets the specific goals of a client. For some clients, it may be relevant to adopt different objective-based models for separate components of their portfolio in order to meet multiple investment objectives.
Traditional models are also a form of objective-based portfolios
Rather than being in conflict with the traditional SAA-based portfolio construction approach, the move to objective-based models simply reflects a broadened choice in terms of the primary objective of portfolio construction.
The traditional approach implicitly assumes the primary objective is to achieve a specified level of volatility, defined by the chosen risk profile. Via the strategic asset allocation applied, return is then maximised within the constraints of this risk target. With risk as the primary portfolio objective, the traditional financial planning approach has evolved to position the client’s risk profile assessment front and centre in portfolio selection.
For some clients, however, experiencing a specified level of risk may not be their most important objective. Return or income goals could be deemed to be more important, and these goals may be in conflict with the client’s risk profile. If this is the case, the financial advisers’ role is crucial in helping the client to trade off the importance of maximising the probability of reaching their goal with having an investment portfolio that will work in line with their risk tolerance. Following discussion about this trade-off, it could be agreed that an objective-based model may be more appropriate for the client than a traditional SAA-based model.
Demand for income objective-based models
Over recent years, the demand from advisers for model portfolios designed to meet specific income objectives has increased. This is at least partially due to the steady reduction in yield being produced from fixed-interest investments.
Traditionally, there was a natural alignment between the typical risk profile of a retiree being skewed toward defensive investments and the desire of retirees to earn income. In the past when interest rates were well above dividend yields, income could be maximised by taking on more fixed-interest investments. This particularly suited retirees with smaller balances, who had the greatest need for higher yields and also the least capacity to take on volatility and sequencing-risk exposure. In this way, models built on traditional SAA benchmarks tended to meet the income requirements of a large proportion of clients.
Today, however, with interest rates falling well below dividend yields, income expectations can often only be met by taking on more, rather than less, equity risk. The more aggressive, traditional SAA-based models may provide the required headline rates of income but they will often be unsuitable for the typical income-seeking retiree. In addition to the risk profile of these more aggressive models being inappropriate, the nature of managed funds means that income from growth vehicles is often lumpy and unpredictable.
Specialised income-oriented models
The unsuitability of traditional SAA-based models to meet the income needs of some clients has led to the development of specialised income-oriented models. In order to generate targeted income levels, these models will have higher equity exposure than normally exists in conservative risk profiles. However, the equity funds chosen may implement strategies to manage downside volatility.
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In addition, funds will be selected on the basis that they have arrangements in place to produce steady and predictable income flows. The mix of asset allocation may also be different to traditional SAA profiles, with a higher allocation to Australian assets and credit-oriented fixed-interest investments being typical of income objective-based models.
It could be argued that objective-based models, such as those designed to raise income levels, move portfolios away from the efficient frontier and as a result are not optimal in a theoretical sense. However, it is important to consider that a client’s objective may not always align well with the attempt to maximise long-term average returns for a specific level of expected risk, which is the basis on which traditional SAA-oriented portfolios are built. The need to meet goals, whether these are expressed in terms of absolute return, income needs or downside aversion may see a greater rise in portfolio strategies that aren’t based primarily on a risk profile.
