Where active ETFs fit in model portfolios

Key takeaways

• Active ETFs can be utilized in model portfolios to reposition faster and offer potentially greater capital and tax efficiency.
• Our team utilizes active ETFs to sharpen our portfolio exposures after making broad asset allocation decisions.

For decades investing has been an active exercise, even as shifts toward low-cost, index-based investments have strengthened. Today, investors are once again evaluating active vehicles to seek enhanced risk-adjusted returns. The Model Portfolio Solutions team at BlackRock sees certain active exposures, select active ETFs, as additive, but today as a finishing touch rather than foundational building block in portfolio construction.

Primary considerations for building a portfolio are determining the investment objective and setting an appropriate risk budget. It’s critical for investors to get these basics right from the outset, often together with their advisor. Given the portfolio objective and risk budget, we begin portfolio construction using core exposures to reflect our benchmark, then incorporating long term tilts, and stacking increasingly fine-tuned tactical positions to gain exposure to attractive market segments.

The process of setting a high benchmark, assembling index building blocks, and layering on compelling factors and sectors based on our team’s signal set has generated solid results since we incepted our model family in 2014.

Recent launches of active ETFs offer new opportunities to make more precise bets, becoming part of the “last mile” in our journey to delivering active returns. We consider these to be the last stretch to amplify outcomes: specialized themes managed by specialist teams; active funds with additive access; rotational strategies; alternatives (alts); and an active core. Sources of alpha beyond our strategic tilts and tactical positions help us tighten our aperture, filling in portfolio gaps and offering distinctly new opportunities.

The road so far

We believe (and academic literature shows) that the vast majority of investment returns come from asset allocation rather than security selection¹. We focus our energy on the goal of getting the right asset allocation; active manager security selection is a complementary rather than primary return driver. Many portfolio builders choose implicitly to build bottom-up: a common practice we have seen in portfolios we customize has been to set aside favorite active managers to establish a portfolio’s foundational building blocks before beginning risk-taking elsewhere.

Our addition of active exposures represents a later development in our history – we began building model portfolios before the modern era of active ETFs. Getting the strategic tilts right seeks to set clients up for success even before tactical positions are layered in. Our strategic tilts are by definition funded from the core standard performance benchmark.

Most of our history has been assembling a harmony of index exposures to further tune our initial strategic tilts. Introducing more instruments over time was a natural evolution: adding new factors and indices as they became available and fitting. In recent years, novel strategies in active ETFs have enabled our team to more finely tune our portfolios.

Our team has recently been making targeted additions of active ETFs to the portfolio to go beyond index capabilities. First, active fixed income ETFs that offer unique access to less integrated markets outside of conventional indices. Heightened access was complemented by rotational strategies, which use systematic investing to navigate shifting market conditions. There have also been thematic additions, pursuing high conviction trends using company-specific active selection. When considering the core, we screen to identify the rare manager whose risk-adjusted return can’t be entirely explained by basic market and factor tilts.

Conclusion

In all of these cases, active ETFs are able to reposition faster and with potentially greater capital and tax efficiency than we would achieve otherwise. As model portfolio managers, we could not replicate this task without substantially increasing the number of portfolio holdings and the cadence of trading. ETFs are a powerful tool for constructing portfolios. The transparent, low-cost, tax-efficient vehicle is ideal for use as a core component of a more holistic investment allocation. The expansive and growing menu of ETFs has enhanced our ability to exploit attractive opportunities and act on investment theses. Even so, the current array of ETFs is not exhaustive, and as more funds become available, we will continue refining our active exposure framework. Last mile allocations embolden the investment palette, helping us deliver better risk-adjusted returns in our model portfolios.