Ursula Marchioni, Head of BlackRock Portfolio Analysis and Solutions, EMEA.
By Ursula Marchioni, Head of BlackRock Portfolio Analysis and Solutions, EMEA.
1) Save time with indexing
It takes time, skill and effort to determine which managers deliver ‘true’ alpha – i.e. returns which are non-systematics and cannot be captured via index solutions. And it takes time to continually monitor and review these managers’ performance.
As the number of products available to investors increases, the cost compounds. There are currently 136,752 different funds domiciled in Europe, nearly twice the number of instruments available a decade ago. The size of these funds (assets under management) varies greatly, suggesting diverse investors’ choices and (in some cases) capacity constraints.
2) Indexing for returns
Selecting active managers requires constant focus. Based on an extensive study of 4,500 alpha managers across 21 asset classes between 1997 and 2017, the BlackRock Investment Institute (BII) looked at the performance persistency of alpha managers within the top quartile over five-year periods. A meaningful persistency probability would be above 25%. Interestingly, this was found to be the case for a few asset classes based on the set of confidence bands. In all other instances: ‘good’ selection of a successful manager could not be set apart from a random choice.
Further research from SPIVA also highlights the inverse relationship between time horizon and the ability of top-performing funds to maintain their position, showcasing that relatively few funds can consistently stay at the top over the long-term. Over five years, only 27% of US equity managers within the top quartile in 2013 remained in the top quartile in 2018. For high yield funds the figure was 28%.
In other words, building portfolios with consistently top-performing managers involves turnover. This constant search, selection, performance assessment, and reselection is a governance cost that should be taken into consideration.
Investors who do not have the capacity to research and regularly monitor their managers may be better off by consolidating the number of alpha-seeking managers in their portfolio and considering greater index selection. These choices will help to make portfolio monitoring more efficient and minimize implementation, transaction and governance costs – while focusing selection skills on the areas of true expertise.
3) Manage risk with indexing
One of the keys components of successful portfolio construction is understanding the risks of the undertaken investments. Unlike returns, risks can be more easily predicted and controlled.
Understanding risk goes beyond looking at products in a siloed approach – and inevitably requires investors to assess, monitor, and manage risks at whole portfolio level.
Often, portfolio construction practices separate asset allocation decisions from product choices. This assumes that by fitting products into an asset allocation, the risk of the portfolio will be aligned with that of the theoretical combination of indices the allocation has been designed with. But when moving from theory to reality, two implementations of the exact same asset allocations can have very different risk profiles. For example, an index implementation of a global 60/40 stock and bond portfolio would have delivered, over the last five years, an annualized risk of 7.2% in USD terms. Implementation with active products – or blends of ETFs and active – would have led to risks varying from 3.5% to 11.5%, depending on the manager.
How technology can help
The BlackRock Portfolio Analysis and Solutions (BPAS) team leverages the power of BlackRock’s risk management platform, Aladdin, to help clients understand and manage risk exposures within their portfolios. Through these interactions, we identify that often there is misalignment between the bets that clients have stated they want to take and those they are actually undertaking. This can be caused by:
- Manager style drift. i.e. choices made by alpha seeking managers over time. Investors select managers for specific purposes, for example, to gain access to an asset class. Within their mandates, managers will be able to deliver on their objective in different ways, and these ‘degrees of freedom’ might lead to overall portfolio exposures which are different from the ones intended at theoretical asset allocation level. Think about sectors, country, currency or factor tilts which weren’t necessarily the focus when selecting the specific manager.
- Over diversification of managers. In this case, products have been chosen for a specific purpose, and successfully in terms of identifying good managers. Yet, many instruments are chosen within each asset class, leading to small allocations to each vehicle. As a result, the combined portfolio resembles one implemented with index vehicles – yet might have higher, ‘alpha-like’ costs.
4) Indexing for control
When it comes to implementing an asset allocation view on a specific market or asset class, indexing can help to control risk and reduce the misalignment between the target and the investable portfolio.
Furthermore, it allows investors to free up risk and fee budgets to express tactical views with conviction through successful alpha managers.
5) Curb costs with indexing
There is more pressure than ever to reduce portfolio costs. Transparency and increased scrutiny on fees are changing distributors’ revenue models, while technology is creating powerful competitors: ‘robo’ advisers and automated offerings that deliver simple and cost-efficient solutions.
6) Indexing for performance
When it comes to performance: costs matter. This is only amplified in a low return environment.
Success goes beyond simply reducing headline management fees: in many instances, accessing strategies at a premium is needed when building towards portfolio outcomes. The real question portfolio builders should ask themselves is: could a similar portfolio outcome be achieved in a more cost-efficient manner?
BlackRock believes that, unless a manager can capture idiosyncratic returns that outweigh their management fee, an index vehicle may be a more cost-efficient way to access the given exposure.
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)