By LARRY SWEDROE
Many asset management firms play a dual role by simultaneously sponsoring funds and providing investment model portfolios that are prepackaged baskets delivered through financial advisers (both independent registered investment advisers and those affiliated with broker-dealers) to investors. Models are generally offered as blueprints for asset allocation and fund selection — financial advisers may not be forced to follow them fully (they may be able to deviate from the allocations recommended for a model portfolio at their discretion).
According to estimates by data provider Broadridge Financial Solutions, models controlled $4.8 trillion of U.S. fund assets in March 2021, up from $3 trillion in March 2020. According to Broadridge, 85 percent of financial advisers employed a combination of custom and model portfolios, and 54 percent of advised assets were in model portfolios.
In March 2021, Morningstar reported that exchange-traded funds (ETFs) issuers and strategists had responded to adviser demand, launching more than 500 model portfolios over the past three years.
Jonathan Brogaard, Nataliya Gerasimova and Ying Liu, authors of the November 2021 study Advising the Advisers: Evidence from ETFs, investigated how model portfolio recommendations shape investments in ETFs and how those models have performed. Their main data source was a unique database for model recommendations created by Morningstar Direct. The models are self-reported by asset managers and third-party strategists. Their sample covered the period 2010-2020 and included 1,045 unique models from 94 companies.
Following is a summary of their findings:
Model recommendations drive the future flows to ETFs — an ETF experienced 1.10 percentage points higher flows per month following its addition to a model recommendation.
Investor flows to funds are sensitive to the fee and quality of the funds. However, investors who chased the recommendations behaved differently, paying less attention to both the price and the performance of the ETFs.
The probability of addition to model portfolio recommendations is higher for affiliated funds, and high fee funds among them are even more likely to be added. The opposite is true for unaffiliated funds—the odds of addition was reduced by 1 percent when the expense ratio increased by one basis point (bp) for unaffiliated ETFs.
Recommended affiliated ETFs — ETFs that belong to the same management company or fund family as the model providers — exhibit worse performance and higher fees than unaffiliated ETFs. There was no evidence supporting the superior performance of affiliated funds relative to unaffiliated funds.
On average, affiliated ETFs charged 6 bps higher expense ratios and generated 67 bps lower net year-to-date returns than unaffiliated funds (significant at the 1 percent confidence level). Their past performance, measured by the performance-rank percentiles over the previous one and three years, was also five and six ranks lower, respectively.
ETFs that were kept in the models exhibited lower performance regardless of their affiliation—they generated negative alphas, and the abnormal returns of ETFs that were added into models were insignificantly different from zero except the negative CAPM alpha of affiliated ETFs — the addition of new ETFs into model portfolios is likely not information driven. Within the group of ETFs that stayed in the models, the affiliated ETFs tended to perform worse than the unaffiliated ETFs.
Of the 34,024 company-ETF-month observations, there were only 17 deletions of affiliated ETFs from models versus 324 deletions of unaffiliated ETFs.
Brogaard, Gerasimova and Liu concluded: “The findings on the choice of affiliated ETFs and their future performance resonate with the fee structure of model providers. The fees they get from financial advisers are independent of the performance of the models. Moreover, when model providers include their own funds into recommendations, they get indirectly compensated through asset management fees charged by these affiliated ETFs. Hence, the model providers might have incentives to recommend funds with high expense ratios.” The authors are being generous — the evidence demonstrates there is no “might” here.
The authors’ findings of biases in the recommendations that negatively impact investors are consistent with those of Nicole Boyson, author of the 2019 study The Worst of Both Worlds? Dual-Registered Investment Advisors. Boyson found that many investment advisers dually registered as broker-dealers failed to fulfil their fiduciary duties to clients. Further, the favouritism toward affiliated funds and lower sensitivity of expense ratios and fund performance in recommendations is consistent with the findings from the 2016 Journal of Finance study It Pays to Set the Menu: Mutual Fund Investment Options in 401(k) Plans that found that mutual fund families usually favor their affiliated funds in the 401(k) plans provided by them. They are also consistent with the findings of the 2019 study Best Buys and Own Brands: Investment Platforms’ Recommendations of Mutual Funds — platforms favour “own brand’” funds and those paying them a higher commission share.
Investor takeaways
The evidence demonstrates that conflicts of interest exist between investors and asset managers who also provide model portfolios that include funds they sponsor — conflicts that affect the quality of recommendations. Asset managers tend to include their own ETFs. Unfortunately, affiliated ETFs, on average, have lower past returns and higher fees than unaffiliated funds, and there is no evidence that the affiliated ETFs provide superior performance after they are recommended. The bottom line is that the conflicts result in underperformance. Thus, investors working with advisers who offer model portfolios should insist that there be no such conflicts (the adviser should be a fiduciary who has selected the funds in the models because the choices are in the best interests of the client).
Note that at Buckingham Wealth Partners, we do provide model portfolios to Buckingham Strategic Wealth advisers. Those models are meant to be used as starting points for discussion, allowing advisers to tailor a portfolio to the unique ability, willingness and need to take risk as well as any preferences an investor might have (for example, a preference for sustainable investments). We also provide model portfolios to advisers who are clients of Buckingham Wealth Partners, our turnkey asset management offering. In either case, Buckingham receives no compensation from any fund providers; thus, we have no incentive to recommend any particular fund. The funds are chosen based on the expense ratio and the amount of exposure to the factors (such as beta, size, value, profitability/quality and momentum) we seek exposure to; thus, we don’t always select the lowest-cost fund. Instead, we select the fund that provides the lowest cost per unit of factor exposure, considering the premium the factor is expected (not guaranteed) to provide.