Overcoming reservations about converting to investment models

Some advisers appreciate what models could do for their business but worry the implementation would be too complicated

May 30, 2019 @ 10:20 am

By Greg Luken

With few exceptions, advisers today should be using investment models, which save time, improve processes and allow them to spend more time with clients, all of which directly correlates to higher profits.

Many advisers will scoff at that, believing the effort they put into building portfolios from scratch offers unique value. Others, however, know what models could do for their business but still feel the implementation process would be too complicated.

(More: Discount pricing could lure more RIAs to outsource asset management)

Based on my discussions with advisers, there are five main reasons they don't convert to models. Here they are, along with how to overcome each one.

1. "I'm not standardized now. It will take too long to get clients on models." Talk to clients about converting to an appropriate model, explaining how it will benefit them (greater efficiency and more time for you to meet their needs). From there, assign models during the next in-person meeting. This process will require work initially, but it won't be as difficult as many believe, and the effort will be worth it.

2. "I have clients who take withdrawals." There are models designed to address the administrative nightmare of continually having to make sure clients have access to cash. They are generally overweight in short-term fixed income and have slightly higher money-market levels, which helps to avoid the need for excess trades.

3. "My clients have large, unrealized capital gains." Suppose a client once worked for XYZ Corp. and during that time amassed company shares that would create significant tax obligations were they to sell them. Some models can isolate a portion of those positions and exclude them from the rebalancing process. That way, clients can spread capital gains out over a period of years and potentially reduce their tax burden.

4. "My client has something similar to a model position with embedded capital gains." If you are working with a good provider of separately managed accounts or an outsourced chief investment officer, or are running the models yourself, there is an easy solution to this problem.

Let's say many of your client portfolios include a low-cost S&P 100 fund, but a model calls for an S&P 500 Index fund instead. Because the correlation and tracking are similar, making this change is not only appropriate but simple. Granted, this process may be more complicated for some large RIA or home office models, but there are ways to overcome that challenge.

5. "I am concerned about high clearing costs." No-transaction-fee funds or exchange-traded funds can help minimize clearing costs on positions that are likely to turn over frequently. Also, many outsourced CIOs or separately managed accounts include a soft rebalance option, which helps to keep models from trading excessively to rebalance only a couple of shares.

If you're implementing models yourself, the "drift" settings can be set higher to limit the number of instances when fractional shares are rebalanced. Trading to achieve a model's preset allocation of, say, 11.5% when the actual number is 12.25% doesn't provide significant benefit.

Greg Luken is president and CEO of Luken Investment Analytics, a Nashville-based investment adviser, and creator of Smart Diversification, a proprietary investment model for financial advisers.


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