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 a decadal shift towards passive investments has endured. Today, we find ourselves as investors once more looking to active vehicles to seek enhanced risk-adjusted returns. The Model Portfolio Solutions team at BlackRock sees active exposures, especially active ETFs as additive, but closer to a finishing touch rather than foundational building block in our portfolio construction.

Our primary considerations for building a portfolio are determining the investment objective and setting an appropriate risk budget. Our clients’ goals are mostly achieved by getting these basics right from the outset, and together with their advisor. From there we begin portfolio construction using core exposures to reflect our benchmark, incorporating our own tilts, and stacking increasingly fine-tuned positions thereafter to gain exposure to attractive parts of the market.

The process of setting a constructive benchmark, placing index building blocks, and layering on compelling factors and sectors to fit our team’s signal set has generated solid results since inception in 2014.

Recent launches of active ETFs offer new opportunities to make more precise bets, becoming part of the “last mile” of our active returns. We consider these to be the last stretch to amplify outcomes: active funds with additive access; rotational strategies; thematic exposures; alternatives (alts); and an active core. Sources of alpha beyond our strategic and tactical portfolio tilts 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, with active manager security selection being complementary rather than our primary return driver. A lot of portfolio managers may choose to implicitly 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 was a later development – we began building model portfolios before the modern era of active ETFs. We first focused on creating a “Strategic Benchmark” which seeks to set clients up for success even before layering on our tactical views. Our Strategic Benchmark aims to diversify away from concentrated factor risks that appear in the standard performance benchmark.

Most of our history has been assembling a harmony of index exposures to further tune our initial Strategic Benchmark. Introducing more instruments over time was a natural evolution of sharpening our sound: adding factors, new indices, and more as they become available. Novel strategies in active ETFs aid our team in further tuning our portfolios to fit the market.

Our team has recently been making targeted active additions to the portfolio to go beyond index capabilities. First, we included fixed income ETFs that offer unique access to reach outside of conventional indices to harvest premia from less liquid, unintegrated markets. Heightened access was complemented by rotational strategies, which use systematic investing to navigate shifting market conditions. There have also been thematic additions, chasing subsector trends while adjusting for company-specific opportunities. When considering the core, we screen to identify managers whose risk-adjusted return can’t be entirely explained by market timing and factor tilts. We have recently been exploring core active ETF allocations that seek outperformance by taking risk through non-consensus security selection, and that have a history of proving it.

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 dramatically increasing portfolio holdings and trading cadence.

ETFs are a powerful tool for constructing portfolios. The transparent, low-cost, tax-efficient vehicle is designed to be the core component of a more holistic investment allocation. The expansive and growing menu of ETFs has benefited our ability to buy attractive opportunities and act on investment theses. Still, the current array of ETFs is not exhaustive of all opportunities that we see in the market. As more funds become available, we will continue refining our active exposure framework. Last mile allocations embolden our toolkit, helping us deliver attractive risk-adjusted returns in our model portfolios.