While model-only investing remains something of a wild frontier, formal due diligence programs will give advisors with the right partners a clear competitive edge.
It was inevitable. After years on the fringes of the asset management landscape, the latest generation of structures for delivering investment ideas has evolved to the point where market gatekeepers are taking it seriously.
When people like Morningstar start rating your solutions, you know you’re on the map. That’s where model-only investing is now, following in the footsteps of mutual funds, ETFs and SMAs.
Morningstar already has about 1,500 outside models on its radar, up about 50% over the past year. That’s an enormous validation of this approach in itself.
Now it’s started applying a version of its familiar analytics to those investment strategies in order to rate their portfolio potential. While barely 100 models have gone through the process so far, it’s clear that this initiative has passed the prototype program stage.
This is the future. And as more models get evaluated and graded, we’ll see real leaders emerge while once-promising hopefuls fade away.
After all, if you aren’t rated, you’re going to have a harder time convincing advisors that you’re even worth their attention much less suitable for a slice of their clients’ assets.
In the next few years, we’re going to see a real shakeout here. While the model universe may ultimately stabilize with as many approaches as today or even more, the days when anyone with ambition and a broadband connection could push an asset mix out to the industry are ending fast.
The End Of The Beginning
A little order can be a good thing. The model-only world is a boisterous and fragmented one. Having someone like Morningstar create a little third-party clarity will help separate solid strategies from what’s already a sea of copycat or functionally useless investment product.
Good, differentiated models will naturally rise to the top of the rating system and attract assets. The right rating can create champions.
As it is, the current gold- and silver-rated leaders are flagships from gigantic money management complexes like BlackRock, Vanguard and American Funds.
BlackRock, for example, provides all the core customization benefits that model-only investing makes possible: tax sensitivity, impact or ESG overlay, the best active management rolled into a single low-cost vehicle.
It’s not hard to imagine a future where that proposition keeps attracting $1 billion a month as advisors pivot away from conventional ETFs and other structures in order to give clients a more streamlined experience.
But while BlackRock is a pillar of the market, other advisors prefer a more diverse landscape loaded with small and more differentiated approaches. We all want to discover something new and exciting.
The model approach can reward innovation by making actual AUM less relevant. Model managers rarely take on investor cash, but instead push out their allocations as well as the surrounding algorithms to the advisors who subscribe to their ideas.
There’s no intrinsic benefit of scale here except as a brute factor of organizational longevity. BlackRock and a niche one-manager shop can compete on a level playing field.
The core of Morningstar’s rating system is performance. If you hit your targets under projected market conditions, the system reportedly smiles on you.
Clarity and Complication
If you’re a manager, now is the time to get your name on the big board.
And if you’re a model marketplace, now is the time to make sure the models you support are equally well validated and vetted.
We can’t help but notice that a lot of the strategies on Orion’s platform (voted #1 TAMP for 2021 by our readers), for example, are already on Morningstar’s screen. There’s quality there and significant curation.
It goes both ways. If you’re a top strategist, advisors are going to want to be able to access your ideas on their platform . . . or they’ll follow you elsewhere.
In the past, the platform providers picked the models they needed, usually with input from their affiliated advisory communities. With outsiders providing rankings of their own, those decisions get more complicated.
Platforms that can’t or won’t open up to the top strategists will find it harder to compete with those that embrace a truly open architecture.
And arguably, a little selectivity will ultimately pay off. Your product shelf can get too deep for advisors to effectively monitor and too crowded to produce good outcomes.
Otherwise, the advisors miss out. The whole point of this approach is that it makes world-class ideas available to all, so getting locked out of the most compelling strategies is not what anyone wants or expects.
It’s unlikely that Morningstar will be asked to rate a lot of bad models or that the managers will maintain a listing in that scenario. But the best of the best will welcome the exposure.
There are still a few vague points in the data. The system draws on Morningstar’s work on relatively static pooled investment vehicles like funds and SMAs, so while the raw portfolio components are there, the discipline around more dynamic models needs careful handling.
When does the strategist buy, sell, rotate or reallocate? It’s an important question that differentiates this methodology from a static index fund or other old-generation structure.
But we’re still in the early stages. Morningstar transformed the industry. Now it’s moving with the sizzle into the future.