Investors have more investment options than ever before, thanks to the number and variety of exchange-traded funds available to everyone. Think of an investment strategy, and it’s probably available in an ETF. But more options also mean more complexity, and the vast ETF landscape invites investors to sort through nearly 3,300 US-based funds to construct a portfolio.
It’s a big ask and one reason some investors turn to investment advisers for help. It’s not much easier for advisers, though, which is why an entire industry of so-called model portfolios has sprung up to manage money for them, essentially off-the-rack portfolios of ETFs to suit every investment style and risk preference. Unhelpfully, there are now as many model portfolios as there are ETFs and maybe more.
One way to narrow the field is to look for model portfolios from big ETF providers, such as BlackRock Inc. and Vanguard Group. Clients get a brand name, and advisers can sleep well knowing that their model provider isn’t going anywhere. Even better, model providers that also provide ETFs don’t have to charge for their models because they make money on the underlying funds.
Model portfolios are already a big business, with about $4.2 trillion in assets, according to Salim Ramji, global head of iShares and index investments at BlackRock. That’s just the beginning. He expects assets in model portfolios to more than double during the next five years. That seems ambitious given how advisers get paid.
From an investor perspective, more adoption would be better. Many advisers still put their clients’ money in overpriced mutual funds that pay the adviser a kickback, often unknown to the client. Of the roughly 24,000 open-end mutual funds in Morningstar’s database, nearly 11,000 charge a 12b-1 fee, a reference to the rule that allows the practice.
These mutual funds are much more expensive than comparable ETFs, with an average annual expense ratio of 1.3%, compared with an average of 0.5% for ETFs. The ETFs in model portfolios are usually even cheaper. In my experience, the weighted average expense ratio of ETF model portfolios is closer to 0.15% to 0.3% a year. ETFs are also generally more tax efficient and cheaper to trade than mutual funds.
The problem for model providers and end clients is that advisers have no financial incentive to transition to ETF model portfolios. On the contrary, many would lose the income they receive from mutual fund companies. Advisers are also paid in part to manage money, with a typical fee of 1% a year to oversee up to $1 million. That fee can include financial planning and other extras, but planning is straightforward for most clients with modest nest eggs, requiring only a few hours a year of advisers’ time at most.
If advisers hand their clients’ money to models, it’ll be harder to justify a 1% fee. They will also no longer be able to assert, as many do, that their portfolios are custom-built for each client, a claim that already strains credulity because there are only so many ways to piece together their chosen stable of funds. The risk for advisers is lower fees while big model providers collect more revenue in their ETFs, effectively an income transfer from advisers to model providers.
Between the two, advisers need income more. The median financial adviser salary was roughly $94,000 a year in 2021, according to US News & World Report, with the highest-paid 25% earning closer to $160,000 a year. Meanwhile, BlackRock made more than $5 billion last year; its median total pay for junior investment professionals is closer to $200,000 a year; and its chief executive officer, Larry Fink, has already amassed $1.4 billion, according to the Bloomberg Billionaires Index.
There’s no obvious workaround. The big providers already give away their models. Sure, they can further reduce expense ratios on their ETFs, but in some cases, ETF fees are already close to zero, and in any case, the savings would go to end clients, not advisers. As long as advisers must justify their own fees, their incentive will be to do as much as possible, including manage money, even if their clients are ultimately worse off for it.
Investors don’t have to be caught in this tug-of-war. They can easily manage their own money by investing in one or two of the smaller number of low-cost ETFs that track broad US or global stock and bond markets. These ETFs can be bought and sold commission-free through any big brokerage.
In the meantime, I wouldn’t count on advisers giving up money management in big numbers. I’ll take the under on BlackRock’s forecast for model portfolio growth over the next five years.
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