The label on the shampoo I used this morning advised me to “lather, rinse, repeat.” This is a clear conflict of interest! The manufacturer gains if I double my consumption of its product. Is the label instruction for my benefit or the manufacturer’s profit? Why have I never seen a shampoo label say “lather, rinse, then go out and buy a competitor’s product for a second shampoo”?
If this sounds too silly for a Bloomberg Opinion column, here is an academic paper making the same points about model portfolios published by asset managers, a $4.9 trillion branch of the U.S. asset management industry.
Large asset managers provide model portfolios for many purposes — as options in 401(k) plans, as blueprints for institutional clients and affiliated financial advisors, and as suggestions for unaffiliated investment advisors. These have the “lather, rinse, repeat” conflict of interest. On one hand, the asset manager wants happy clients, so it wants the model portfolios to perform well. On the other hand, it wants investment management fees, so it has incentives to recommend its own products, especially ones with the highest fees.
The same conflict exists in nearly every transaction. The seller wants satisfied customers — for repeat business and good word of mouth if nothing else — but also wants to get the most money for the least costly goods and services. Conflicts of interest are not evil. What matters is whether they are disclosed and how they are managed.
Model portfolios come with an explicit disclosure of the conflict. Moreover, any financial adviser who doesn’t understand without specific disclosure that asset managers profit when investors use their products should find another profession. There are strategists not affiliated with investment managers who provide model portfolios, and they charge for the service. Financial advisers have to know that investment managers giving away model portfolios free are making money from it in other ways. To manage conflicts, large asset managers monitor recommendations to ensure quality. Skeptical readers may question how carefully disclosures are read, and how sincere oversight is, but there’s nothing inherently dishonest about a producer recommending its own products.
The first problem with the paper is it analyzes model portfolios investment-by-investment. This defeats the purpose. Model portfolios are not intended to be lists of the best individual investments, but carefully balanced combinations of investments with the best portfolio characteristics, including risk, return, income, tax and other features. This is like criticizing the recipes that come on Philadelphia Cream Cheese packages (back when any was available) for recommending too many ingredients manufactured by parent company KraftHeinz. A recipe is not good or bad based on who makes its ingredients, but on how the result tastes.
The next complaint is that the average fees of affiliated investments in model portfolios are higher than the average fees of unaffiliated investments. There is a substantial body of opinion that retail investment managers add no value, so investors should select the cheapest funds that are reasonably well run. But one does not expect retail investment management companies to share this opinion, nor people who ask those companies to construct portfolios.
For example, if BlackRock Inc. includes in a model portfolio its corporate bond ETF that has a 0.14% expense ratio instead of one from Vanguard Group Inc. that has a 0.04% expense ratio, it’s presumably because BlackRock thinks its product is worth the extra cost. If it didn’t, it would be violating its clear legal fiduciary duty to fund investors. That’s a much bigger problem than putting it in model portfolios for unaffiliated financial advisors, to whom BlackRock has no specific legal duties.
There’s another body of opinion that investors should select funds with good historical performance. Usually this means a blended 10-year history balancing risk and return, as illustrated by Morningstar star ratings. The paper’s authors complain that affiliated model portfolio selections have worse year-to-date, one-year and three-year returns than unaffiliated selections. But the reason advisors use model portfolios is they promise analysis far beyond three short-term performance measures. The models try to incorporate all history, and also add forward-looking views. They consider risk as well as return. They consider correlations — how an investment fits in with the overall portfolio — and not just historical return and standard deviation. And they offer different portfolios depending on income needs, tax situation, risk tolerance, investment horizon, and other differences among investors.
Finally, the paper complains that the affiliated investment choices do not have clearly superior future performance than the unaffiliated choices. But it would be very surprising if they did, because that would mean all affiliated model portfolio investments recommended by all investment managers had statistically significant market-beating performance as a group. We know it’s very rare for any retail fund to have statistically significant market-beating performance. The right question isn’t how the affiliated investments in a model portfolio perform relative to the unaffiliated on an absolute basis, it’s how well the combined model portfolio performs relative to its stated goals.
Financial institutions, and particularly retail investment managers and advisors, are treated with suspicion beyond what is applied to shampoo and cream cheese. The routine conflicts of interest from all transactions are treated as inherently evil. Each individual investment in a portfolio is supposed to work on a standalone basis, rather than being evaluated in the context of an overall portfolio delivering what it promises. Fees beyond minimum operating expenses are considered unjustified, and all investments are supposed to beat all benchmarks over all time periods.
If this level of suspicion seems reasonable to you, then you should ignore model portfolios. Put your money in the cheapest index funds you can find, with the greatest diversification. You might consider buying generic shampoo and cream cheese as well.
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