Despite the important role financial advisors play in the design of client portfolios, we know very little about how those portfolios are constructed. New research shows, however, that the model portfolios used by advisors suffer from a number of structural inefficiencies.
That research was motivated by the need to answer the following questions:
- What are the general characteristics of advisor portfolios?
- Which macroeconomic and style (such as size, value, momentum, quality and low volatility) factors do portfolios have exposure to?
- Are there commonalities in the type and number of positions held in advisor portfolios?
- How do advisor portfolios differ and along what dimensions?
- Could the risk-return trade-offs of these portfolios be improved, especially in the context of hypothetical scenarios of adverse market conditions?
Regulatory authorities do not collect advisor portfolio information, and there are no widely available centralized datasets on the holdings and risk characteristics of advisor portfolios. To answer these important questions, Brian Lawler, Brett Mossman, Patrick Nolan and Andrew Ang of BlackRock analyzed 9,940 model portfolios provided by advisors from September 30, 2017, to September 30, 2018. They grouped advisor portfolios on a spectrum from conservative portfolios, which hold less than 30% in equities, to aggressive portfolios, which hold more than 80% in equities. The following is a summary of the key findings from their study, Factors and Advisor Portfolios, which was published in the spring 2020 issue of The Journal of Wealth Management:
- Most advisor model portfolios have moderate risk aversion, defined as having an equity weight of 50% to 65%.
- The average portfolio expense ratio is 0.54%, with the 5th and 95th percentiles being 0.14% and 0.96%, respectively. Advisor models holding alternative products tend to have higher fees, as alternatives tend to be more expensive.
- For the 88% of advisor model portfolios with moderate conservative to aggressive risk tolerances (those with equity allocations greater than 30%), economic growth risk accounts for the vast majority (74.7%) of portfolio risk (as defined by volatility). Equity risk is the dominant type of risk across all risk contributions because the relative level of equity volatility is significantly higher than the volatilities of other asset classes, and the majority of advisor portfolios hold more than 50% of equities.
- Those portfolios do not have meaningful exposure to most equity style factors, with the exception of a significant tilt to small-size stocks. The average loadings to other rewarded style factors of value, momentum, quality and low volatility do not significantly differ from market benchmarks.
- Advisor model equity portfolios exhibit a significant home bias, holding just 23% of international assets, about half the share of non-U.S. holdings in the MSCI All Country World Index (ACWI).
- In fixed income portfolios, advisor models hold much shorter duration exposures than fixed income market benchmarks – despite the fact that longer duration bonds provide greater diversification for equity risks. They also tend to take much more credit risk than the Bloomberg Barclays U.S. Aggregate Bond Index benchmark, despite the fact that, historically, default risk has not been well rewarded. From 1926 through 2019, the default premium was just 0.25%.
In light of the perception by many investors that factors have become overcrowded, reducing or eliminating their premium, an interesting finding was that advisor portfolios have no significant exposure to any equity style factor other than size. One would think that if anyone would be aware of the literature and seek to exploit the findings of factor premiums, it would be an advisor. Yet, we don’t see any exposure to other styles besides size. This is another argument against the overcrowding story.
Their findings led the authors to conclude that there are several ways in which advisors could improve the risk-return trade-offs for their clients. The change that might produce the largest improvement on risk-adjusted returns in advisor portfolios is to reduce the concentrated exposure to economic growth (via exposure to market beta). Second, create more intentional exposure and consistent tilts in persistently rewarded factors, potentially leading to either better risk-adjusted or absolute expected returns. Finally, adding duration and reducing equity risk in portfolios may help increase the potential benefits in common risk scenarios portrayed during slowing economic growth conditions.
Those recommendations would have historically improved portfolio efficiency, both improving returns and reducing risk. The third recommendation also cut the left tail risk. Their recommendations are entirely consistent with those proposed in the 2018 edition of my book, Reducing the Risk of Black Swans, co-authored with my colleague Kevin Grogan.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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