Money management: Why you should be wary of “model” portfolios

These days, some of the most misleading ads you’ll see concern so-called “model portfolios.” All too many brokers use these model portfolios to build their money management business.

For instance, one recent ad claimed that its model portfolio turned $100,000 in 2000 into more than $1.7 million by 2009. It says the model outperformed the S&P/TSX 60 market index in every one of those 10 years. It says the model returned 124.6% in 2003, compared to a 22.9% return for the market. For 2009, it claims the model returned 90.0%, compared to 27.9% for the market.

However, as the ad explains in the fine print, these calculations don’t reflect trading that actually happened. Nobody turned $100,000 into $1.7 million. Instead, the fine print explains that the results show “hypothetical or simulated performance” and are “not meant to represent actual performance results.”

Model portfolios can be managed much more aggressively than real money

Hypothetical model-portfolio accounts have a great advantage over real-world money management. For one thing, it’s safe to manage them much more aggressively than when you are playing with real money. This hyper-aggressive money management gives the hypothetical account great returns when it succeeds. It runs up much steeper losses when it fails, of course … but the losses are only hypothetical, and easily disposed of.

When the losses reach embarrassing levels, the broker can simply forget the old hypothetical account. It can then start over.

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Brokers may start up several hypothetical accounts, and eliminate all but the top performers over a period of years until they are left with just one hypothetical account that makes their money management look brilliant. Mutual-fund companies do the same. Fund company employees refer to the start-ups as “incubator funds.” These funds have little money in them, so it’s inexpensive to treat them in such a way that they build a great record. It’s even easier for a broker to build a top performance record for a hypothetical account where there’s no money involved.

Money management: “Front running” can further skew model portfolio results

Unlike a real-money account, a hypothetical account can legally profit from front-running. When a broker’s research department plans to issue a strong buy recommendation and a thick research report in a rising market, it will generally add the stock to the model portfolio and issue the report simultaneously. That means the model portfolio will “buy” the stock instantly, but the firm’s brokers will need time to scan the report and call their clients.

Over the course of a week, a $10 stock can rise to $10.50 or even $11 in a situation like that. These near risk-free 5% to 10% gains can have an enormous impact on the model portfolio’s hypothetical profit, especially when they compound over 10 or 15 years.

Model portfolio results are not always calculated in real time

Some model portfolios have an even more blatant advantage over real world money management: buys and sells in the portfolio are calculated as if they took place at the closing price of the previous day. This alone gives you the magic wand you need to claim extraordinary results without any investment analysis.

All you need to do is simply check the market just before the close every day for stocks that have risen 5% or more since the previous day. Then you “buy” the ones that went up, and “sell” any you own that went down, in each case at the closing price of the previous day.

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