Wall Street's Model Portfolios Are Misunderstood

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.