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Portfolio > Portfolio Construction

Could FSPs Be Emotional Rescue for Advisors?

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During the December 2018 turmoil in the markets, were self-directed advisors or advisor portfolio managers (APMs) affected by emotions more than fund strategist portfolios (FSPs), those funds created with ETFs and mutual funds and traded by firms like BlackRock?

It appears, on the surface, that emotion took some type of toll, as self-directed advisors’ performance was worse than FSPs, according to an Envestnet report comparing the two groups in the December period.

The report compared December performance for each asset risk level, from capital preservation, conservative, moderate, moderate growth and aggressive growth, and in each, advisor models lagged, especially when including standard deviation. For example, in aggressive growth, advisor models were down 7.08% with a 3.80% SD, while FSPs were down 6.96% with a 1.81% SD. The largest differential in performance was in the most conservative, capital preservation, with advisor models down 1.88% (2.43% SD) while FSPs were down 0.86% (1.28% SD).

But perhaps “emotional” isn’t the right word as it connotes a knee-jerk reaction based on market volatility, argues John Harris, managing director and head of global advisor sales at Envestnet. “I don’t think that’s what’s happening here,” he says.

He points out that over a three-year period, advisor models outperformed FSPs but had taken on more volatility and risk: An Envestnet study between the second quarter of 2015 and the first quarter of 2018 showed average performance for advisor models was 4.61% with an SD of 2.57%, while over the same period, FSP average performance was 4.10% with an SD of 1.13%.

He describes three reasons for the differential that might explain December:

  • The bull market made advisors and clients more comfortable with equity investing, and advisor models allowed for “more equity exposure that definitely would impact the downside when markets go down 9% in a month,” Harris explains.
  • As advisor models are more likely to customize client portfolios, there may be more legacy stock positions — for example, a retired client who owned his former company stock and wanted to hang onto it — or the portfolio may be holding onto stock for tax reasons, Harris says.

“Advisor-directed portfolios have individuals making decisions and they are allowed to open up the parameter a bit beyond what an FSP [could do],” Harris says. “An FSP manager would never accept outside positions into strategies. It’s either take those strategies that they’re creating and believe in them, or don’t. It’s a tighter process.”

  • Rebalancing plays a part as well, Harris says. For example, with an FSP there is quarterly or semiannual rebalancing, whereas for an advisor model, it’s at the discretion of the advisor. “They may be letting winners ride, or maybe it’s tax season, but it could be number of things that come into play and why they haven’t rebalanced the model,” Harris says.

That could be a detriment to the portfolio, as Envestnet found that today rebalancing could add 30 basis points of performance to the portfolio.

Harris says the advisor portfolios may have been more heavily weighted equity-wise, which caused the poorer performance, and that could be tied to the points above. “It wasn’t that they made a quick irrational decision, but it was a long-term persistent emotion to edge into equities and to keep legacy positions that they love. Or maybe they did not rebalance the portfolios because they thought markets were going up and they wanted to ride that opportunity.”

Advisors who want to customize portfolios and offer flexibility to clients still can offer FSP-like portfolios without going all in to an FSP, Harris says. For example, advisor models have the option of partnering with third-party firms that could take on their smaller accounts so the managers have more time to work their business and larger clients. Or they could build a series of base portfolios adjusted for client risk, and “customize the edges” by allowing certain legacy stocks, etc.

In regard to cost, Harris says that “cost is always a factor,” but even those for FSPs “have come down dramatically,” especially as ETF expense ratios have come down.

Still Harris is a strong believer in FSPs because they have an institutional view of the market, are not emotional and are methodical in their trading. An FSP and advisor model “probably over the long term could be pretty close to each other in performance,” he says. “It’s more about consistency of the ride.”

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