SEC eyes model ETF portfolios

The SEC is examining the burgeoning business of financial advisers' selling model portfolios of exchange-traded funds.

The SEC is examining the burgeoning business of financial advisers’ selling model portfolios of exchange-traded funds.

Industry experts worry that many of the advisers offering these model portfolios aren’t sophisticated enough to do the proper due diligence on the underlying ETFs and are making performance claims that can’t be verified. In the long run, they contend, investors could get hurt.

“The practice has come to the attention of the staff, and they are looking at various aspects,” John Heine, a Securities and Exchange Commission spokesman, wrote in an e-mail.

Model ETF portfolios, in which advisers manage a portfolio of securities for other advisers or investors, have grown in popularity in recent months as people turn away from traditional mutual funds.

And with the explosion of ETFs coming to market, the pending 12(b)-1 reform proposal and the increase in advisers who adopt fee-based models, industry observers predict that demand for model portfolios will continue to swell.

The average total operating expenses for an asset-weighted actively managed domestic equity fund was 0.92% as of last year, compared with 0.3% for a domestic equity ETF, according to Strategic Insight.

“Everyone and their brother has a model portfolio — and of course, every model portfolio has outperformed the market, which is complete nonsense,” said Richard Ferri, founder of Portfolio Solutions LLC, a registered investment adviser that manages $800 million in assets. “The trouble is, there is no verification of most of these models because they didn’t exist two years ago. There is no history.”

Regulators have become so concerned about the proliferation of advisers offering model portfolios that they approached Mr. Ferri and Scott Burns, an analyst at Morningstar Inc., to consult with staff members about potentially instituting regulations.

“One of our gripes to the Securities and Exchange Commission and the Financial Industry Regulatory Authority [Inc.] is that there is no regulation,” Mr. Burns said. “People are out there pitching portfolios, saying they have beaten the S&P 500, but if those portfolios are 4% fixed income and 10% gold, they could have owned three ETFs and had the same results at lower costs.”

Mr. Heine declined to comment beyond confirming the fact that the SEC is looking into the issue.

Calls to Nancy Condon, a Finra spokeswoman, weren’t returned by press time.

Not everyone believes the model portfolio industry needs regulation.

“It depends very much how they are being offered to the market,” said Melissa Nassar, a principal in the financial adviser services group at The Vanguard Group Inc. “If they are pitched as investment products, then that would fall under the purview of regulation.”

Other large ETF providers, such as BlackRock Inc., The Charles Schwab Corp. and State Street Global Advisers Inc. are responding to the demand by offering, or are considering offering, model ETF portfolios or tools to advisers. Vanguard offers ETF model portfolios to some clients and is discussing rolling a service out for its financial adviser clients, Ms. Nassar said.

“We hear a lot from advisers asking what we are thinking in terms of asset allocation and what we think of their models,” she said. The firm doesn’t have a timetable for when it will make a decision.

For two years, BlackRock has offered adviser clients a quarterly list of advisers who create ETF model portfolios. The firm performs basic due diligence on the managers and requires only that they have a year-long track record, said Sue Thompson, a managing director and head of the registered investment adviser and independent channel at iShares, the ETF division of BlackRock.

Like Vanguard, BlackRock is discussing how it could offer its asset allocation expertise on ETFs to advisers and plan sponsors, she said.

State Street Global Advisers has heard from many advisers in need of help with their model ETF portfolios, said Anthony Rochte, a senior managing director.

“We hear, “I am overwhelmed with the 900 different ideas in the ETF industry. How do I put that together?’” Mr. Rochte said. “This is a trend we have heard more and more of over the past 18 months.”

An insurance company has just hired SSgA to created ETF models for its financial advisers, Mr. Rochte said. He declined to identify the firm.

Schwab has seen increased demand over the past three years for its wrap program, which includes exchange-traded funds, said David Lindenbaum, a vice president of managed accounts.

Schwab announced last month that it is acquiring Windward Investment Management Inc., which allocates its $4 billion in client investments among ETFs based on perceived mispricing in 42 global asset classes. Twenty-five percent of Windward’s clients were registered investment advisers who were buying its model ETF portfolios.

“Advisers like ETFs because of low cost and liquidity, but they also like the niche markets that ETFs can go into,” Mr. Lindenbaum said. He declined to comment on how Schwab will expand on Windward’s offering after the acquisition closes later this year.

As advisers continue to have doubts about the performance of actively managed mutual funds, more will turn to model portfolios of ETFs, said Tom Lydon, president of Global Trends Investments.

“Ten years ago, the average adviser may have had 80% of their portfolios in core buy-and-hold, but today it’s as low as 30%,” Mr. Lydon said. “That bodes well for this trend.”

E-mail Jessica Toonkel at [email protected].