A model portfolio is a product. Canadian regulators say so directly: model portfolios made available to clients are expected to go through a Know-Your-Product assessment at the model level, and to be approved before they're offered.[2] That assessment describes the model as it stood on the day it was approved - its objectives and strategy, what it holds, its features, costs and risks.
Then the model starts to change. Its manager adds and removes holdings. Target weights are adjusted. The funds inside it replace their own portfolio managers or raise their fees. Market moves shift its risk profile. None of these changes is dramatic on its own, but together they can leave a firm with a model whose KYP file describes a product that no longer exists. That gap - between the model as assessed and the model as it now stands - is model drift.
This paper treats model drift as a KYP problem. It covers what the rules in Canada and the US require of firms that offer models as products, four kinds of drift that can make a model's KYP assessment stale, which model changes should reopen that assessment, how to set tolerance ranges on the model's documented characteristics, and what a firm needs to monitor and document to show its KYP of each model is current.
Its scope is deliberately narrow. It's about the model as a product - what the firm and its registered individuals need to know about it. How individual client accounts are aligned to a model is a separate subject and isn't covered here. For how material changes in individual securities are detected and escalated, see Material Change: When to Reopen a KYP Assessment; for the wider operating model, see The Continuous KYP Playbook: Who Does What.
Canada treats the model as a product in its own right, with KYP obligations at both the firm and the individual level. The US reaches a similar place through the diligence required before recommending an investment strategy. In both, the understanding has to be of the model as it is, not as it was.
In the KYP HubHow products are approved onto the shelf, whatever their type: Product Approval.
CIRO's Rule 3301 requires a dealer, before making securities available to clients, to take reasonable steps to assess them, approve them, and "monitor the securities or derivatives for significant changes."[1] Rule 3302 separately requires each Approved Person to take steps to understand what they buy, sell or recommend, including its "structure, features, risks, initial and ongoing costs and the impact of those costs."[1] Joint CSA/CIRO Staff Notice 31-368 applies both obligations to model portfolios.
Among the KYP deficiencies the notice reported were firms that offered model portfolios without first assessing and documenting their "investment objectives and strategies, composition, features, costs, risks," and the investors they were intended for.[2] Its guidance is direct:
Under Rule 3301, a dealer must take reasonable steps to approve what it makes available to clients, and an Approved Person may only buy or recommend what the firm has approved.[1] The notice applies the same logic to models: firms "are also expected to have a process to approve model portfolios that are made available to clients."[2] Among the approval deficiencies it reported were firms that offered models managed by the firm or an affiliate without keeping evidence the models had been approved. Separately, among its KYP assessment findings, it described large firms that relied solely on an affiliate's KYP work to discharge their own obligations.[2]
The notice leaves the design of the approval process to the firm, but sets a clear floor for what it has to produce:
For model drift, approval does a second job that's easy to miss. The approved model is the baseline every later version is measured against. If the approval record doesn't capture what the model was - its holdings, target weights, costs, risk rating and tolerance ranges - the firm has nothing to measure drift from, and can't show whether today's model is still the product that was approved.
Rule 3301(1)(iii) requires the firm to monitor what it has approved for significant changes.[1] The notice extends that to models: among the monitoring deficiencies it reported were firms that lacked a process, or failed to keep evidence that "securities or model portfolios were reviewed for significant changes."[2] Its guidance sets out what the process needs:
The notice also expects firms to keep written policies and evidence that the process was followed, to document their assessment of any significant change, and to consider responses including notifying registered individuals, revisiting the firm's approval and restricting new sales.[2] It criticized firms that relied passively on issuers to tell them something had changed.[2] By analogy, a firm offering a third-party model can't rely only on the model manager to report changes; it needs its own view of what the model holds and how it's behaving.
For a model, monitoring runs at two levels at once. The underlying securities are each monitored on their own schedule, as they would be anywhere on the shelf. The model is monitored against its approved baseline: is it still composed, priced and risk-rated the way its approval says? Drift shows up at the second level even when nothing at the first level has fired.
The clause numbers, timeframes and thresholds above are illustrations of what a complete written process covers, not recommended settings. The notice is explicit that processes can vary with a firm's business model and the complexity and risks of what it offers;[2] what can't vary is that the process is written down, followed, and evidenced.
The notice splits the individual KYP obligation for models in two:
This split matters for drift. The people building the model need current knowledge of every underlying security. The people offering it to clients need current knowledge of the model as a whole. When the model changes, both groups' understanding goes out of date at the same moment, and the firm is expected to give them access to what it learned through its own KYP process, along with any training and tools they need.[2]
Finally, the notice's list of what KYP policies and procedures should cover includes "the process to perform KYP on model portfolios offered by the firm and the specific responsibilities of registered individuals in respect of KYP (i.e., performing KYP at the model portfolio level versus at the level of individual securities in the model portfolio)," alongside a description of "what the firm considers to be a significant KYP change."[2] A firm that offers models needs both written down, for models as well as securities.
US rules don't single out model portfolios, and there's no counterpart to the Canadian notice's model-level KYP expectation. The product-level diligence duty still reaches models, because a model is an investment strategy and both the broker-dealer and adviser frameworks require firms to understand a strategy before recommending it.
Reg BI applies to recommendations of "any securities transaction or investment strategy involving securities (including account recommendations)."[4] The first component of its Care Obligation is product-level: the broker-dealer must understand the potential risks, rewards and costs of the recommendation and have a reasonable basis to believe it could be in the best interest of at least some retail customers.[4][5] For a model, that means understanding the strategy, its holdings and its costs - and keeping that understanding current as the model changes.
The SEC's 2019 interpretation of the adviser standard of conduct sets a comparable bar:
A KYP file that describes last year's version of a model is exactly the kind of inaccurate or incomplete information the interpretation warns against.
FINRA's guidance on new products treats approval as the start of a review cycle, not the end. Notice to Members 05-26 describes post-approval review of complex or conditionally approved products as a best practice.[6] Regulatory Notice 12-03 asks firms to periodically reassess complex products they offer to confirm that their performance and risk profile remain consistent with how the firm is selling them.[7] Applied to models, the question is the same: does the model still match what the firm said it was?
| KYP Question for a Model | Canada (CIRO / CSA) | United States |
|---|---|---|
| Must the model be assessed as a product? | Yes - KYP at the model portfolio level | Yes in substance - the strategy must be understood before it is recommended |
| Must it be approved before it is offered? | Expected - a process to approve models made available to clients | No specific rule; covered by FINRA new-product review practices for broker-dealers |
| Must it be monitored for change? | Yes - models are reviewed for significant changes, with evidence kept | Implied - understanding must stay current; FINRA expects periodic reassessment of complex products |
| What must individuals understand? | Client-facing: the model as a whole. Model builders: every underlying security | The risks, rewards and costs of the strategy being recommended |
A model's KYP assessment records a set of facts: what it holds, what it's trying to do, what it costs, how risky it is. Model drift is any change that makes one of those facts untrue. There are four kinds, and each goes out of date in a different way.
This is the drift a firm causes itself, through the model's own management decisions. Each new holding brings its own KYP requirement: the people selecting securities for the model must understand each underlying security.[2] Each change also alters the model as a whole, which is what client-facing registered individuals are expected to understand.[2] Individually small changes add up: a model that has replaced a third of its holdings over two years is a materially different product from the one in its original KYP file, even if no single change seemed significant.
A model can change character without changing a single holding. Market movement shifts its effective asset mix between rebalances. A growth-oriented fund inside a "balanced" model can gradually tilt the whole model's style. Concentration in a sector or region can build as holdings perform unevenly. The KYP question is whether the model's documented objectives, strategy and risk still describe what it actually does. This is the kind of drift most often missed, because nothing in the model's change log records it.
Costs are a named element of KYP under Rule 3302 - initial and ongoing costs, and their impact.[1] A model's total cost is the sum of its layers: the model or program fee, the management expense ratios of any funds inside it, and the trading costs generated by its turnover. Any layer can move independently. A fee increase in one underlying fund, a switch from an ETF to an actively managed fund, or a more active rebalancing policy can each change the model's cost profile. The notice lists changes in costs and fees among the significant changes firms monitor for.[2]
Every security inside a model is also subject to monitoring for significant changes in its own right. When one of them changes - a fund replaces its portfolio manager, an issuer's credit rating is cut, a fund suspends redemptions - the model hasn't been edited, but the model's KYP may no longer hold. The question isn't only whether the underlying security should stay on the shelf; it's whether the model that holds it still has the features and risks its assessment describes. The trigger framework for underlying changes is set out in Material Change Monitoring; the point here is that every trigger on an underlying security needs a route to the model KYP files that depend on it.
Not every change to a model needs a fresh assessment. Returning holdings to their existing target weights doesn't change what the model is. Adding a new asset class does. The notice expects firms to describe in writing what they consider a significant KYP change,[2] and for firms that offer models, that description needs to cover the model as well as its securities. The table below applies that expectation to common model changes. It's a starting point for a firm's own policy, not a prescribed list.
| Model Change | Reopens Model KYP? | KYP Question | Expected Action |
|---|---|---|---|
| Rebalance to existing target weights | No | None - the model is being restored to its assessed form | Record the rebalance in the model's log |
| Add a new holding | Yes | Is the new security understood, and how does it change the model's features, costs and risks? | Underlying KYP on the new security; update the model's assessment; inform client-facing staff |
| Remove a holding | Usually | Does removing it change the model's exposures, diversification or cost? | Record the rationale; update the assessment if exposures or costs change |
| Change target weights | Depends on size | Does the new mix still match the model's documented objective and risk? | Assess against the model's tolerance ranges; update the assessment if outside them |
| Add or remove an asset class | Yes | Has the model's strategy changed? | Full reassessment and re-approval of the model |
| Change the model's stated objective or strategy | Yes | Is this the same product? | Treat as a new model: full assessment and approval before it is offered |
| Change in the model manager or sub-advisor | Yes | Will the model be run the way the assessment assumed? | Reassess the model's process and people; inform client-facing staff |
| Significant change in an underlying security | Yes | Does the change alter the model's features, risks or costs? | Assess impact at the model level as well as the security level; record the outcome |
| Change in the model's total cost | Yes | Are the model's documented costs and their impact still accurate? | Update the cost section of the assessment; inform client-facing staff |
The pattern is that any change to what the model is, what it holds for more than a moment, what it costs, or who runs it reopens the KYP file. Mechanical actions that return the model to its assessed state don't.
Characteristic drift and cost drift don't arrive as discrete events, so they need thresholds. The practical approach is to record, in the model's KYP assessment, a documented range for each characteristic that defines it, and to treat a breach of that range as a significant change in the model.
| Characteristic | What the Range Covers | Why It Matters for KYP |
|---|---|---|
| Asset mix | Minimum and maximum weight for each asset class | The asset mix is the model's composition as described to clients and staff |
| Risk | A range for a chosen risk measure, such as trailing volatility, and the model's risk rating | A risk rating that no longer fits the model makes the assessment inaccurate |
| Concentration | Maximum weight in any single holding, issuer, sector or region | Concentration changes the model's risk profile even when the asset mix is stable |
| Cost | A ceiling on the model's total weighted cost | Costs and their impact are a named element of KYP |
| Liquidity | Maximum weight in holdings with limited or restricted redemption | Liquidity is a feature of the model that affects how it can be used |
| Turnover | A range for annual turnover | Turnover drives trading costs and signals changes in how the model is run |
No regulator in either country prescribes these ranges, and no single set fits every model. Two design points apply broadly. First, ranges should be set at the level of detail the model is described at: if a model is marketed as "60/40," the asset-mix range should be tight enough that "60/40" stays true. Second, ranges should be tighter on the parts of the model that carry the most risk or the least liquidity, where a small drift in weight is a larger change in the product.
A model's KYP file is only as current as the process that maintains it. That process has to watch the model, its underlying securities and the knowledge of the people who offer it.
In the KYP HubHow monitoring rules, the engine and alerts work: Material Change. What happens when an alert fires: From Alert to Decision. When a change should reopen KYP: Material Change: When to Reopen a KYP Assessment. The same lifecycle for other security types: equities, mutual funds and ETFs, structured products, segregated funds and annuities and alternatives and private markets.
The notice found annual monitoring alone insufficient for securities in general,[2] and a model is only as current as the securities inside it. Model monitoring works as a chain, where each link can surface drift the others miss:
The second link is the one most often missing. Firms that monitor securities well may still never compare the model as a whole to its own documentation, which is the only way to catch characteristic drift and cumulative composition drift. A single underlying security can be unremarkable while the model it sits in has quietly become something else.
The fourth link closes the loop to Rule 3302. Client-facing staff are expected to understand how each model is composed and what its features and risks are.[2] If the model changes and they aren't told, their understanding is out of date whether or not they've done anything wrong. The notice's own examples of firm practices include updating due diligence memos or key elements of KYP assessments, informing all registered individuals of significant changes, and retaining all document versions.[2]
In the KYP HubWhat the KYP file must show: KYP Documentation: What Your File Must Show. How supervision tests it: Supervising a KYP Program.
The notice expects firms to keep evidence that their monitoring process was followed.[2] For a model, that means the KYP file can't be a single document overwritten each time the model changes. It needs to be a versioned record that shows what the model was at any point, what changed, and who reviewed it.
| Record | What It Shows |
|---|---|
| Model KYP assessment (versioned) | Objectives, strategy, composition, features, costs, risks and intended investors, with every prior version retained |
| Model approval record | Who approved the model, when, and on what basis - and each re-approval after a significant change |
| Documented tolerance ranges | The ranges for asset mix, risk, concentration, cost, liquidity and turnover that define the model |
| Model change log | Every change to holdings, weights, manager or strategy, with its date and rationale, and whether it reopened KYP |
| Underlying KYP files | A current assessment for every security in the model, linked to the models that hold it |
| Evaluation log | Each time the model was compared to its ranges, including the times nothing was breached |
| Staff notification record | Which registered individuals were told about each significant model change, and when |
The test of the whole system is whether the firm can answer, for any model on any date: what did it hold, what did it cost, what did its assessment say, was it within its ranges, and did the people offering it know about the latest change? If any of those answers has to be reconstructed after the fact, the model's KYP isn't being maintained - it's being rebuilt on request.