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Wall Street’s ‘model portfolio’ boom slammed into new paper

(Bloomberg) — A rapidly growing $4.9 trillion arm of the US asset management industry is funneling investor cash into funds that are overvalued and underperforming compared to alternatives, new research claims.

So-called model portfolios — off-the-shelf investment strategies often involving bundles of ETFs — are plagued by conflicts of interest that undermine one of the hottest and most opaque businesses on Wall Street, argue a trio of academics. Is.

These allocation blueprints, typically created by asset managers and deployed by financial advisors, have exploded in popularity in recent years as easy, one-stop solutions for investors of all stripes.

Yet the firms that design them favor their own exchange-traded funds, wrote Jonathan Brogaard, Natalia Gerasimova and Ying Liu. And advisors are passing money to clients with little regard for what this means for performance.

“These affiliated ETFs have, on average, lower past returns and higher fees than unaffiliated funds,” the team said. “We also haven’t found evidence that affiliate ETFs provide better performance then recommendation.”

These are big claims against a business that churns out billions in and out of ETFs every day. Model portfolio assets have more than doubled in the past five years, and Broadridge Financial Solutions projects they could double again to $10 trillion by 2025.

Read more: BlackRock and TwoSigma Quant models shape the portfolio boom

Many providers of the model are asset managers, who benefit from new cash coming into their funds. Meanwhile, financial advisors have adopted them as a way to outsource allocation decisions so that more time can be spent attracting and serving clients.

Yet investors are rarely innocent victims. The paper states that many models follow recommendations blindly and pay little attention to fees and performance.

“Investors who pursue recommendations also behave differently, as they pay less attention to both the ETF’s price and performance,” the study found.

Brogaard at the University of Utah, Gerasimova at the Norwegian School of Economics and Liu at the Shanghai University of Finance and Economics tracked the effects of model changes in Morningstar data between 2010 and 2020.

They found that an ETF achieves a 1.1 percentage point higher in flow per month after being included in a recommendation, or a model. Demand for featured products also tends to be less sensitive to fees and past performance.

ETFs owned by the same parent company are more than three times as likely to be added to a model — despite fees that are on average six basis points higher and 67 basis points lower year-over-year than unaffiliated funds. ,

The findings are the latest iteration of long-standing concerns that major Wall Street firms use one business line to promote another, regardless of the cost to the end-investor. Previous studies have found that investment platforms and retirement-planning providers, for example, tend to favor the same brand of funds.

There has been increasing anecdotal evidence for some time on the impact of model portfolios. Several external ETF flows in recent years have been linked to adjustments in larger models.

For example, a strategy change by BlackRock Inc. in July attracted a record daily inflow of inflation-protected bonds into its ETF. The world’s largest asset manager has also added its core ESG fund to its model portfolio, which has helped generate $18 billion in inflows over two years.

The paper, titled “Advising the Advisors: Evidence from ETFs,” is among the first to document the sway of these portfolios.

“Despite a growing number of model recommendations, little is known about how they affect financial advisors’ investment choices,” the academics wrote. “Our goal is to add to the industry and regulatory debate about the ambiguity of model portfolios.”

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