While model portfolios are created to help investment firms improve their scale and efficiency, their recent proliferation have created new obstacles for managers. This paper discusses the unintended consequences of model portfolio "webs" and how they may actually introduce risk and complicate client engagement.
Model portfolio explosion is not without its challenges
The surge in demand for model portfolios has created an ever-increasing web for investment groups to manage. With competition increasing, successful managers are offering much more than a base set of models. Instead, an additional layer of model customisation is helping to differentiate their offering and better reflect the unique needs of each client. But what is now apparent is that success has introduced new challenges. Faced with an expanding and tangled web of model portfolios, there is a risk that scale, oversight and the quality of a manager’s client engagement suffers.
When 5 becomes 100 - model customisation leads to model proliferation
In many asset and wealth managers, investment teams are tasked with building a base set of model portfolios. These leverage unique inputs such as capital market assumptions and optimisation techniques. For example, a base set of 5 model portfolios is created and managed to reflect different risk and return profiles, each with a unique asset mix. Work then begins to commercialise them.
Complexity arises fast however as internal and external clients demand customised versions to reflect unique needs. Take the example of a financial advisor firm that requires that the 5 models fit their asset (and platform) universe and include unique constraints or objectives. That very same client may want additional variations, such as another range of lower cost model portfolios, or a set to meet ESG criteria. While each model leverages the same asset projections and portfolio construction process, the investment team must quickly flex to meet those needs.
Consequently, with just one client, the investment team must suddenly design and manage 10 or more new models. This can become even more complex when the client seeks help in linking models to the portfolios of their underlying clients. This example is just one client that an investment team may serve. But add in new clients and it’s easy to see how models can quickly multiply and get tangled.
Model proliferation makes governance much harder
A tangled web of model portfolios creates challenges for oversight. With popularity rising, so too are expectations that the FCA will tighten its scrutiny of the market. Therefore, chief investment officers, investment committees and compliance teams must comprehensively oversee their full range of models, ensuring consistency in both realised and expected outcomes. With ever more models, the risk increases that a portfolio drifts away from its target allocation and so expected and realised outcomes diverge.
To overcome this requires a strong framework that aligns the complex hierarchy of model and client portfolios. From this, analysing a wide set of ex post and ex ante analytics becomes possible. But for many investment groups that face a disparate mix of systems and data sources, manual processes are plugging gaps. Clearly this needs to be industrialised.
Client teams suffering on the front line
The challenges of model proliferation are not confined to the investment team. As models become customised for different client needs, so too does the required service package. After all, a client with a unique suite of models also expects a unique suite of information. Offering a standard presentation, factsheet and quarterly report simply won’t suffice.
Instead, customising service means customising the mix of quantitative and qualitative information that a client receives, including its format and frequency. For many groups, managing client specific needs is a manual task. But for successful managers, having a fully customised service package is a powerful differentiator.
Connectivity is the key to unlocking scale in a customised world
For dominant players in the model portfolio market, the welcome AUM boost has somewhat overshadowed the scale, governance and service challenges that can come with success. And without doubt, model customisation and proliferation will only continue. It’s a necessity to both better serve client needs and differentiate in an increasingly competitive space.
For those providers ahead of the game, success need not be at the expense of scale, governance and service issues. The solution lies in ensuring connectivity across the different stages of their model portfolio process. From the initial model design, to management and client engagement, providers must focus on how they can better connect the component parts - the data, technologies, analytics and people. Only then can a tangled web of model portfolios become untangled.
About Jacobi:
Jacobi's technology has its roots in institutional investment management and brings together investment expertise and a market-leading technology platform. Headquartered in San Francisco with offices in London, UK, and Brisbane, Australia, the company is led by a team of experienced investment professionals and engineers.
