Morningstar Magazine - June/July 2018 - 52

Spotlight: Packaged Investing

Evidence of this popularity is provided by a recent
report by the consultancy Lang Cat.1 It showed
that 84% of U.K. advisors now operate a
"centralised investment proposition" or standardized investment solution, covering 80% of the
assets they are investing on behalf of
clients. Of these advisors, 62% use some form
of outsourced investment management.
This includes both model portfolios supplied
by investment consultants but implemented by the
advisors themselves, and managed portfolios,
which are implemented on a discretionary basis
by an asset manager. Both approaches are
popular and share several common characteristics,
but they are best-suited for different advisor
business models.
The Evolution of Outsourcing

The future of these strategies, therefore,
depends upon the evolution of the advice model.
To understand how investment propositions
may evolve, we must first understand how we
reached our present state.
The advisor community has transformed over
the past 25 years, especially here in the United
Kingdom. From the advent of compulsory
qualifications in the mid-1990s through to the
regulatory overhaul of the Retail Distribution
Review a few years ago, advisors have
faced numerous challenges to their business
model. Like any evolutionary system, each
challenge was overcome by those able to adapt
to the new environment.
One of the most notable changes was the
decline in the use of insurance company products
in favor of portfolios of mutual funds. This
corresponded with advisors increasingly defining
their service as investment advice.
After the global financial crisis of 2008, though,
many advisors saw a need for additional help in
building portfolios that more closely aligned to the
risk profile of their clients. This help was often
found in model portfolios supplied by investment
consultants and implemented by advisors.

1 "You Have Reached Your Destination," Lang Cat, December 2017.

Morningstar June/July 2018

Pros and Cons of Model Portfolios

Model portfolios are widely used today, though
there are drawbacks. An enduring advantage
of model portfolios is that the advisor remains
in control of the investment proposition and client
experience. In many cases, clients are unaware
that the model portfolios are supported by a third
party. The downside of control, however, is that it
is necessarily accompanied by responsibility. While
many advisors have embraced the responsibility
of creating portfolios for clients, the implementation of the portfolio can be more troublesome.
Although many platforms are adept at
implementing model portfolios, most U.K. advisors
do not have discretionary permissions. They
need to seek permission for each portfolio change
from every client. This requires considerable
administrative work, which may hinder an advisor
from taking actions recommended by the model
portfolio provider. If clients fail to give permission,
portfolios may become misaligned with the
models. That in turn can have a knock-on impact
on reporting and performance. What's more,
advisors tend to use more than one platform, and
may have to use different funds to implement
portfolios across the platforms they use,
or else limit their selections to funds listed on all
the platforms they use.
In short, model portfolios typically require advisors
to make a considerable investment of time and
resources. Such an investment makes sense when
advisors define their value proposition as
investment specialists. However, an increasing
number of advisors are emphasizing their focus on
financial planning rather than investing.

Meanwhile, as portfolio services become
commoditized, behavioral science is revealing
the value of advisors as financial coaches. Advisors
can show significant value by engaging with
their client on goals-based planning and improving
investor behavior. Of course, the challenge
of a coaching model is that it requires the advisor
to spend more time with clients, necessitating
the streamlining of the business model to reduce
operational costs.
Such a business model is naturally aligned
to a managed portfolio service where both the
investment decisions and the execution are
undertaken by the portfolio manager on a
discretionary basis. Although advisors lose the
benefits of presenting their own portfolios to
clients, they gain efficiencies and get to "sit on the
same side of the table" as the client. They can
demonstrate value by critically appraising the work
of the managed portfolio provider, while focusing
on the financial goals and behavior of their clients.
An Eye for the Future

Both model and managed portfolios have
advantages. The right choice is linked to an
advisor's choice of business model. The current
environment appears to favor the eventual
dominance of the coaching model, which suggests
the future dominance of managed portfolios.
The growing interest in managed portfolios is
also being boosted by an ongoing decline in costs,
presumably as managed portfolio providers
use the benefits of scale to reduce the impact
of fees on returns. Managed portfolio services still
tend to carry higher costs than model portfolios,
but the gap is shrinking.

Growing Demand for Managed Portfolios

The increasing popularity of passive investment
and direct-to-consumer propositions has
contributed to the growing commoditization
of portfolio services. One driver of this popularity
is undoubtedly the poor relative performance
of active managers over the past few years, and
hence may prove to be cyclical. But a more
important secular trend appears to be greater
transparency on costs.

Advisors must be clear about the benefits and
drawbacks of each service before recommending
one. Ultimately, human relationships have an
enduring appeal and a power to change behavior-
and that service is very difficult to outsource. K
Dan Kemp is chief investment officer, EMEA, for
Morningstar Investment Management Europe. He is a
member of the editorial board of Morningstar magazine.

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