Book Smarts and Street Smarts: Why managed account portfolios need both

When it comes to managed account portfolio construction, a copy-and-paste approach from traditional funds may not serve advisers and clients well.

Clarity on the role of managed accounts in the context of the advice landscape is key. How will it be explained to clients? How will clients experience and perceive the value of advice delivered via managed accounts? How can the structure of managed accounts, and the unique benefits they bring, be unlocked to their full potential along the client's advice journey?

Here are some of the key considerations that marry the "book smarts" of traditional portfolio construction with the "street smarts" stemming from a deep understanding of advice.

Clients and advisers are benefiting from using managed accounts. They're making their lives easier, not harder.

Three examples that illustrate what this has meant for how we approach portfolio construction include:

• We are less likely to consider funds that are complex in nature and therefore difficult to explain to clients. If portfolio transparency isn't matched by transparency of the underlying funds, this is a recipe for difficult client conversations. Few things are more frustrating than trying to explain results only to be met with a confusing "black box" explanation.
• The "optimal" number of building blocks is likely lower than for a managed fund. With greater transparency of the underlying building blocks, advisers need to be equipped with the necessary information to support client questions, including explaining that fewer building blocks does not mean less diversification.
• Relatedly, a 1 or 1.5% allocation to a particular building block may work on a spreadsheet, but it makes less sense in the "real world" of advice. These "rats and mice" allocations rarely move the dial in terms of portfolio outcome. They simply add unnecessary complexity to advisers' lives.

A final word: more building blocks doesn't always equal meaningful diversification, and vice versa. We believe we can achieve sophistication without complexity.

Confident advisers emphasise value, not cost, to clients. They also understand that portfolios are more than just their component funds and building blocks, and are able to convey this to their clients in a non-technical, jargon-free way. Put differently, portfolios are translations of an underlying philosophy.

In the case of the First Choice Flex portfolios, advisers can personify them as street-smart bargain hunters, prepared to shop at different grocery stores to prise out "specials" and identify substitutes. This "spend wisely" rather than "spend less" philosophy is what endears Flex to advisers.

What does this look like in practice?

• One, Flex spends its "active fee budget" judiciously. Instead of keeping a similar proportion of active and passive across asset classes, Flex is prepared to take a more active approach where the evidence points to higher bang for buck, and vice versa. For example, we take a largely passive or enhanced approach in large-cap Australian Equities, and use the fee savings in more alpha-rich areas of the portfolio such as Global Equities.
• Two, when building versions of Flex on different platforms, we prioritise client value over more superficial measures of consistency, such as replicating the managers used. The best-value Global Small-Cap manager on one platform may not be the best-value option on another. Consistency is judged through the lens of look-through risk modelling and scenario stress tests rather than cosmetic similarity.

Markets don't behave today the way they did a decade ago. We've noticed:

• The velocity of markets increasing
• Traditional defensive assets failing in a higher-inflation regime
• Many traditional active managers underperforming, particularly concentrated, style-based and fundamental managers
• Geopolitics playing a bigger role: fiscal policy turbocharged economies out of COVID, the Ukraine and Iran conflicts triggered supply-side inflation, and "Trump 2.0" is shaking up the world order

We believe the old model of strategic asset allocation (SAA) and a heavy reliance on traditional active managers (stockpickers) is less effective in the new market regime.

The modern toolkit is far broader than the old active-versus-passive debate. Today's "secret sauce" includes:

• Enhanced and systematic strategies that sit between traditional active and passive investing
• Targeted or specialist beta exposures, such as gold, high yield or selective regional allocations

Used thoughtfully, these tools can help portfolios seize opportunities more effectively (offence) and become more resilient across a wider range of market environments (defence).

We no longer see ourselves purely as a multi-manager team selecting funds from a menu. We think like multi-asset investors, willing to use the best tool for the job, whether it's active, passive or enhanced, a fund, an ETF or a direct share. This willingness to use the best tool for the job, whether active, passive or enhanced; whether a fund, ETF or direct share, reflects our team's evolution from being multi-manager investors to true multi-asset allocators.

I've always been fascinated by behavioural finance because it focuses on how people actually behave, rather than the ultra-rational investors described in textbooks.

It's also a reminder that problems can be solved in different ways. Rory Sutherland's Alchemy gives a simple example: ask an engineer how to improve commuter satisfaction and they'll suggest faster trains; ask a psychologist and they may simply add more seats or charging stations to make the journey more pleasant.

Portfolio construction is no different. A client's sleep-well-at-night factor can be improved through sophisticated hedging strategies, driven by the portfolio constructor. It can also be improved through education, communication and familiarity with what they own, driven by the adviser.

Managed accounts are a natural arena for both schools of thought to shine. The challenge is that efficiency is often invisible and therefore underappreciated. Advisers need to think not only about how managed accounts deliver value, but how they demonstrate it.

A few examples:

• Use underperformers to show diversification in action. Transparency around underlying holdings inevitably draws attention to underperformers. Rather than avoiding those conversations, use them to demonstrate diversification at work. Proper diversification means having to explain differing performance across the portfolio. What you don't want is everything firing at once.
• Expand the discussion beyond volatility and highlight trade-offs. Investments that feel safe in the short term, like cash, can be the riskiest over the long term because they fail to preserve purchasing power.
• Recognise that perceptions of risk are personal and often generational. Some clients, typically older, need to be calmed when volatility hits, while others, typically younger, see sell-offs as bargain-hunting opportunities.
• Contextualise performance, don't simply report it. How many clients understand the market environments in which active will outperform passive, and vice versa? Why might a manager-heavy portfolio underperform when stock concentration is high? What is different about the current environment that clients might not have experienced before?

Taking advantage of the managed account "efficiency dividend" is only half the battle. Deciding how to spend it is a key strategic decision for advisers. Some might increase the number of clients served, while others might increase client touchpoints to lift perceived value. The latter approach leans much more heavily on transparency of holdings, regular portfolio reporting and portfolio change rationale communications.