For example, if BlackRock Inc. includes in a model portfolio its corporate bond ETF that has a 0.14% expense ratio instead of one from Vanguard Group Inc. that has a 0.04% expense ratio, it’s presumably because BlackRock thinks its product is worth the extra cost. If it didn’t, it would be violating its clear legal fiduciary duty to fund investors. That’s a much bigger problem than putting it in model portfolios for unaffiliated financial advisors, to whom BlackRock has no specific legal duties.
There’s another body of opinion that investors should select funds with good historical performance. Usually this means a blended 10-year history balancing risk and return, as illustrated by Morningstar star ratings. The paper’s authors complain that affiliated model portfolio selections have worse year-to-date, one-year and three-year returns than unaffiliated selections. But the reason advisors use model portfolios is they promise analysis far beyond three short-term performance measures. The models try to incorporate all history, and also add forward-looking views. They consider risk as well as return. They consider correlations—how an investment fits in with the overall portfolio—and not just historical return and standard deviation. And they offer different portfolios depending on income needs, tax situation, risk tolerance, investment horizon, and other differences among investors.
Finally, the paper complains that the affiliated investment choices do not have clearly superior future performance than the unaffiliated choices. But it would be very surprising if they did, because that would mean all affiliated model portfolio investments recommended by all investment managers had statistically significant market-beating performance as a group. We know it’s very rare for any retail fund to have statistically significant market-beating performance. The right question isn’t how the affiliated investments in a model portfolio perform relative to the unaffiliated on an absolute basis, it’s how well the combined model portfolio performs relative to its stated goals.
Financial institutions, and particularly retail investment managers and advisors, are treated with suspicion beyond what is applied to shampoo and cream cheese. The routine conflicts of interest from all transactions are treated as inherently evil. Each individual investment in a portfolio is supposed to work on a standalone basis, rather than being evaluated in the context of an overall portfolio delivering what it promises. Fees beyond minimum operating expenses are considered unjustified, and all investments are supposed to beat all benchmarks over all time periods.
If this level of suspicion seems reasonable to you, then you should ignore model portfolios. Put your money in the cheapest index funds you can find, with the greatest diversification. You might consider buying generic shampoo and cream cheese as well.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.