In practice:
Solving portfolio challenges with indexing

The action

Investors need to know what they are buying and identify the main drivers behind their portfolio returns.

In this instance, whilst each of the below alpha-seeking managers had generated alpha; when combined their active bets had negated each other.

The portfolio was overdiversified, resulting in a portfolio where a large portion of portfolio risk was driven by broad market exposures, and therefore potentially replicable with an index solution.

Source: BlackRock, as at August 2019. Chart assesses ex-ante active risk of three active mutual funds with the same benchmark. Combined exposure (ABC) is an equal weighted combination of the three funds.

Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

Moving beyond an asset class siloed approach between ‘active vs passive’ and instead determining the optimal index and alpha split at a portfolio level, resulted in a greater allocation to indexing across exposures.

Taking a blended approach, and using indexing as an efficient way to express broad market views, increase the portfolio information ratio, and enable the client to maximise the efficiency of risk and fee budget allocations.

The action

Stress testing portfolio outcomes can help to identify ways to improve portfolio outcomes. BlackRock’s range of scenarios, based on simulations of future possible outcomes of macro and geopolitical events can help managers to conceptualise resultant economic, market and portfolio alpha impacts.

Emerging Market Equity Manager

• Country Overlay
• Factor Overlay
• Emerging Market Equity Manager

Strategic Allocation

 

Tactical Overlay

Hypothetical stress test analysis:

Source: BlackRock, as at August 2019. Equity Volatility Increase represented by a move in the VIX index by 16.5%. EM Rebound based on MSCI Emerging Markets Index up 10%. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

The liquidity of the ETF market, helping to minimise costs of accessing these exposures, led the client to increasingly utilise these tools to dynamically tilt the portfolio in accordance with market events.

The action

With the ability to take on slightly more credit and/or duration risk, blending across investment tools and looking beyond money market funds, can help to bring portfolios closer to their yield requirements.

Cash and equivalents allocations:

Source: BlackRock, as at December 2018. Currency = GBP. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

The growth in the liquidity of the ETF market provided assurance that the client would be able to quickly execute large trade orders when required, without paying a large spread or risking not being able to liquidate.

The action

ETFs can act as an interim vehicle to holding cash, whilst allowing investors to gain access to the broad economic exposures of the asset class before the capital calls are made.

• Example liquid proxy to Private Equity - Buyouts
• Listed Private Equity
• Small Cap Equities
• Value Equities
• High Yield

Macro
Exposures

Style
Exposures

Source: BlackRock, as at August 2019. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

The liquidity of the ETF market enabled them to be used as tactical investments solutions to help manage cash flows and allow the portfolio to remain more closely aligned to their strategic asset allocation.

The action

Through decomposing the drivers of return, we identified that a large portion of the excess returns generated by some alpha-seeking managers could be tied to static exposures from factors, and not from “pure alpha”.

Example of manager return decomposition

Source: BlackRock, as at August 2019. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

Recognising that the outperformance was frequently tied to static factor tilts, the client realised that they were potentially overpaying for returns.

By taking a more balanced allocation across index, factors and alpha, the client was able to maximise the efficiency of their risk and fee budget.

The action

Liquid beta sleeves, constructed using ETF building blocks, helps investors avoid holding excess cash, and enables them to stay invested and closer to their strategic asset allocation (SAA) without compromising on liquidity.

Option 1 - Money market fund

Money Market Fund - 100%

Total Expense Ratio: 10 bps
Resulting Tracking Error to SAA: 7.3%

Option 2 - 5 ETFs designed to replicate the SAA below

Total Expense Ratio: 16 bps - Resulting Tracking Error to SAA: 1.1%

Source: BlackRock, as at August 2019. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

Understanding that not all liquidity was needed on a T+0 basis, the client was able to take on additional risk to help reduce the funding gap between their liabilities.

The action

To help manage cash flows stemming from uncalled capital and expiring vintages, ETFs can act as an alternative to holding cash that allow investors to gain access to the broad economic exposures of the asset class before the capital calls are made.

• Example liquid proxy to Private Equity - Buyouts
• Listed Private Equity
• Small Cap Equities
• Value Equities
• High Yield

Macro
Exposures

Style
Exposures

Source: BlackRock, as at August 2019. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

The liquidity of the ETF market made ETFs a valuable tool as tactical investments solutions to help manage cash flows in a more targeted manner whilst reducing the risk of a funding shortfall.

The action

BlackRock can help by assessing portfolio efficiency and identify the main drivers of risk and returns.

Identifying where returns are largely driven from broad market exposures and static exposures to factors, can help to ascertain where similar outcomes may be potentially replicable more cost-effectively through an index solution.

In this example whilst the alpha-seeking manager generated excess returns, much of this was attributed to static factor tilts.

Example of manager return decomposition

Source: BlackRock, as at August 2019. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

Recognising that the manager outperformance was tied to static factor tilts, the client realised that they were potentially overpaying for returns.

By taking a more balanced allocation across index, factors and alpha-seeking managers, the client was able to maximise the efficiency of their risk and fee.

The action

The growth of index building blocks screened for ESG criteria can help clients to easily implement sustainable decisions into their investment process, whilst keeping aligned to their strategic asset allocation.

BlackRock can help in decomposing ESG portfolio scores and in identifying ways to enhance sustainability ratings.

Source: BlackRock, MSCI ESG Research as at December 2018. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

The rules-based approach to defining the universe and standards for ESG characteristics within indexing enabled the client to incorporate substantially criteria in a transparent and low-cost manner whilst remaining aligned to their investment policy benchmarks.

The action

BlackRock can help build customised solutions that manage portfolio risk whilst achieving a positive yield, and avoiding cash drag.

Cash and equivalents allocations:

Source: BlackRock, as at December 2018. Currency = GBP. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

Understanding that not all liquidity was needed on a T+0 basis, the client was able to invest some money in short-duration fixed income ETFs which increased yield without significantly changing the liquidity profile.

The action

BlackRock can help by assessing the efficiency of clients’ portfolios and identifying the main drivers of returns.

In this instance, we found that a large portion of portfolio risk was driven by broad market exposures, and therefore potentially replicable with an index solution.

Whilst each alpha seeking manager generated alpha; when combined their active bets had negated each other. The client had overdiversified their portfolio.

Source: BlackRock, as at August 2019. Chart assesses ex-ante active risk of three active mutual funds with the same benchmark. Combined exposure (ABC) is an equal weighted combination of the three funds.

Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

Indexing is an efficient tool for expressing broad market views.

An indexed core of the portfolio, complemented by a select group of high octane alpha-seeking managers helped increase net return and reduce portfolio costs. Due to the more selective investment approach, more time could be dedicated to research per manager leading to increased quality of alpha-seeking managers.

The action

BlackRock can partner with clients to perform stress testing analysis and assess how the portfolio might perform under different scenarios.

We showcased that through the use of a tactical overlay using ETFs, the client was able to construct a portfolio that was protected in the instance of a market volatility increase, but remained invested to harness gains in the event of an EM rally.

Emerging Market Equity Manager

• Country Overlay
• Factor Overlay
• Emerging Market Equity Manager

Strategic Allocation

 

Tactical Overlay

Hypothetical stress test analysis:

Source: BlackRock, as at August 2019. Equity Volatility Increase represented by a move in the VIX index by 16.5%. EM Rebound based on MSCI Emerging Markets Index up 10%. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

The liquidity of the ETF market, helping to minimise costs of accessing these exposures, led the client to increasingly utilise these tools to dynamically tilt the portfolio in accordance with market events.

The action

BlackRock can help build customised solutions to manage portfolio risk whilst achieving a positive yield, and avoiding cash drag.

Cash and equivalents allocations:

Source: BlackRock, as at December 2018. Currency = GBP. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

Understanding that not all liquidity was needed on a T+0 basis, the client was able to invest some money in short-duration fixed income ETFs which increased yield without significantly changing the liquidity profile.

The action

BlackRock can help better understand ESG metrics at the portfolio level and identify ways to improve these metrics.

Through optimisation techniques that balance risk, return, cost and ESG criteria, we can help to build a sustainable portfolio where the incorporation of ‘values’ does not have to mean giving up value.

Source: BlackRock, MSCI ESG Research as at December 2018. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

The growth of index strategies screened for ESG criteria provided the granularity and flexibility to easily implement sustainable decisions into their investment processes in a low-cost manner.

The action

BlackRock can help with decomposing drivers of returns.

In this case, we identified by breaking down the excess return of some of their existing alpha-seeking managers, a large portion of that generated could be attributed to static exposures from factors, and not from “pure alpha”.

Example of manager return decomposition

Source: BlackRock, as at August 2019. Case studies are for illustrative purposes only; they are not meant as a guarantee of any future results or experience, and should not be interpreted as advice or a recommendation.

Why index more?

Recognising that this alpha-seeking manager’s outperformance was tied to static factor tilts, the client realised that they were potentially overpaying for returns.

By taking a more balanced allocation across index, factors and alpha, the client was able to maximise the efficiency of their risk and fee budget.