BlackRock believes that the adoption of ETFs and index funds at the core of portfolios will increase from around 10% today to 50% and potentially beyond as investors re-think their portfolio construction.
Ursula Marchioni, Head of BlackRock Portfolio Analysis and Solutions (BPAS) EMEA.
In a research note, the asset management titan behind the iShares brand of ETFs noted that profound changes in Europe’s finance industry are reshaping the way institutions are building portfolios as a result of end clients demanding more for their money.
Against this backdrop, whereby distributors and asset managers are re-evaluating their portfolio construction practices to drive greater efficiency, BlackRock advocates the importance of a holistic approach to portfolio construction.
It notes that current practices too often involve siloed decision-making which separates asset allocation decisions from product choices, leading to suboptimal outcomes for end clients.
Ursula Marchioni, Head of BlackRock Portfolio Analysis and Solutions (BPAS) EMEA, writes, “The implementation of a new approach begins with a re-thinking of the drivers of portfolio returns.”
BlackRock identifies four components, rooted in academic research, which together determine a portfolio’s performance: broad market exposures with static tilts to rewarded factors; asset class market timing; factor market timing; and security selection.”
Marchioni notes, however, that these components are not equal. Academic literature suggests the bulk of portfolio returns – well above 90% – are linked to asset allocation choices and static factor tilts: the core of portfolios.
BlackRock believes the surge in the number and variety of index products in recent years means they are well placed to act as building blocks in portfolios as ETFs now offer the breadth and granularity of exposures needed to reach most asset classes and factors.
“Across asset classes, ETFs deliver precise access to specific countries, market capitalisation segments and sectors,” writes Marchioni. “Growing pockets of product innovation revolve around sustainable funds and thematic exposures. The availability of style factor-based exposures is also growing — simplifying access to established rewarded factors such as value, momentum, size, quality and low volatility that, until recently, were only available via alpha-seeking strategies.”
One of the most favourable features of ETFs, however, is their relatively low cost compared to other investment vehicles.
BlackRock highlights the importance of this benefit in a case study: A European private bank asked BlackRock to partner towards achieving superior efficiencies in their fund-of-funds offering — with the ultimate goals of reducing fees in the underlying funds and boosting net returns for end clients.
BlackRock found that a large portion of the portfolio risk was driven by exposure to broad market tilts — and was therefore replicable with a portfolio of ETFs. It built an ETF-based proxy portfolio that showed similar macro and style risk factors versus the original portfolio; equally, the two portfolios behaved similarly in backward-looking performance analyses.
Yet, the new portfolio had the potential to reduce the average expense ratio by nearly 50% (29bps). “With the reduction in fees of the investments that capture similar macro and style risk factors, the client was now able to spend more resources — both within dollar and risk terms — of the alpha-seeking section of the portfolio, leading the client to make extensive product substitutions,” writes Marchioni.
BlackRock believes this evolution to portfolio construction will be powered by technology – new developments to portfolio monitoring and risk management systems will give investors greater ability to analyse and compare products, improve clarity on the type of returns delivered by managers, and deliver precise insights on the most cost-effective route to access them. New practices will be organised around a continuous flow of integrated activities with asset allocation, product choices and ex-post monitoring feeding into one another.
While the firm predicts a massive increase in the adoption of passive products such as ETFs due to the forces mentioned above, BlackRock also foresees the emergence of new opportunities for true alpha-seeking managers.
Marchioni writes, “Replacing ‘active funds’ that just deliver benchmark hugging returns or static factor tilts with indexing will create more room to focus on real alpha and alternatives where, in our view, investors will remain happy to access strategies at a premium.”