Model Portfolio: What It Is and How It Works

Creating an investment portfolio on your own is a challenging task to take on. You need to determine your risk tolerance, research suitable investment options, and rebalance from time to time to maintain your preferred asset allocation.

Those can take up a significant amount of your time, and there is a huge potential for risks if you have a lapse of judgment.

Model portfolios offer a cost-effective way to have your desired investment portfolio by opting for an existing one instead of making a tailored, diversified set of assets from scratch.

Model Portfolio Explained

A model portfolio is a collection of diversified investments designed to meet a particular goal or achieve a specific balance risk/reward ratio. It is a customized investment portfolio constructed by a financial expert and can include various assets such as stocks, bonds, and other securities in different industries.

The professional investment manager in charge of the portfolio will handle the investments as per the given rules and adjust the portfolio when necessary based on market events.

With model portfolios, investment advisors can provide their clients with pre-made portfolios managed by some of the top investment firms instead of producing personal portfolios for every one of their clients.

Model Portfolios vs. Funds

Model portfolios work like mutual funds and exchange-traded funds (ETFs), pooling the money of several small investors to create an extensive investment portfolio in which each of them has a share in.

What separates a model portfolio from funds is that it is not directly investable. Unlike mutual funds and ETFs, which you can invest in on your own, a model portfolio will require a financial advisor’s assistance for access.

Model portfolios can also comprise a broader range of investments. Funds often consist of stocks and bonds, while model portfolios could have real estate investment trusts (REITs), managed futures, and inverse ETFs.

In addition, such an investment portfolio may include mutual funds and ETFs, compared to mutual funds and ETFs that don’t typically bet on each other outside of preferred strategies.

Types of Model Portfolios

Model portfolios are designed to meet certain goals. Therefore investors need to choose ones that are well-suited for their needs.

For example, a growth model portfolio could have high-risk, high-reward growth stocks.

On the other hand, a capital preservation model portfolio might primarily include safe fixed-income securities such as bonds and money market funds to prevent losses at the cost of not earning a significant amount of money.

Other types of model of portfolios include the multi-manager fund, which can invest in multiple funds (‘fund of fund’ approach) or through different accounts (‘manager of manager’ approach).

An environmental, social, and governance (ESG) portfolio aims to maximize returns while practicing socially responsible investing. If you want a portfolio that can protect your returns during market downturns, an ESG portfolio can help you with that.

Now if you’re looking to be tax-efficient with your investing, a tax-optimized portfolio focuses on reducing your capital gains tax through different strategies.

Model portfolios can also employ more advanced strategies, such as the long-short equity strategy, which is frequently used by hedge funds but applied less often by mutual funds and ETFs.

With the long-short strategy, the managers combine long and short positions. That way, they can profit from a rising market by investing more in risk-based stocks and betting on other assets during a falling market to mitigate any downside in the portfolio.

Keep in mind that sophisticated investment strategies require more trading and active management, which can expose you to higher risk and more costs.

Choosing a Model Portfolio

If you think your investment goals are achievable through a model portfolio, here are some tips to help you find a suitable one:

  • Determine Goals and Time Horizon

Every model portfolio is built for a different purpose and uses a particular strategy. That is why it’s important that you first have a clear set of financial goals.

  • Compare

Model portfolios not only differ in design and objective. The underlying investment vehicle, trading frequency, and risk level are also different for every model portfolio.

  • Review Performance History, Fees, and Conditions

A model portfolio contains a prospectus or private placement memorandum (PPM) that includes comprehensive information about the portfolio’s performance, fees, and conditions. Such data is usually available on the financial advisor’s or fund manager’s website.

  • Track Model Manager’s Commentary

You can follow your model manager’s public commentary to understand their way of thinking, learn about their market perspectives, and ensure that their investment beliefs continue to be in line with yours.

  • Consult a Financial Advisor

Should you decide to use a model portfolio, working together with your financial advisor can help you start the fund and choose a model portfolio suitable for your long-term investment goals.

Reasons to Opt For a Model Portfolio

  • Ease of Use

Ease of use is one of the main reasons model portfolios remain popular. With a model portfolio, you have a complete investment solution that allows you to passively meet your financial goals.

You don’t need to decide on the portfolio’s design or tweak the investments over time. Instead, you only have to determine your goals, and the model portfolio team will take care of the rest.

  • Diversification

Model portfolios help investors achieve diversification easier and for less cost. You don’t need to invest a lot in different asset classes. Some accept a minimum of $10,000 for the initial investment.

  • Low Costs

Unlike hedge funds and actively managed mutual funds that try to outperform the stock market, model portfolios are typically low-cost, although they cost more than simple options such as index funds.

If you want a complex approach beyond investing in index funds, a model portfolio is a low-cost way to do that.

  • Excellent Management

Model portfolios are managed by investment firms that have become household names in their respective countries and the world.

  • Efficiency

Instead of spending much time working on a portfolio’s design for each of their clients, model portfolios let financial and investment advisors put more time and effort into helping clients and their financial plans.

That allows them to take care of things such as tax management, insurance, and estate planning.

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