Regulation, technology and evolving client needs demand a re-think of portfolio construction that will revolutionise the role of index strategies in portfolios, according to a note – entitled ‘Time to get your core in shape’ – from BlackRock’s Ursula Marchioni examining the new ‘active’ approach sweeping through European portfolios.
Marchioni believes that successful portfolios in a post-MiFID world focus on outcomes with greater time and budget inefficiency.
“Modern portfolios recognise and seek out the main drivers of return for a portfolio – broad market exposures and factor tilts – also known as the ‘core’ of the portfolio. 2019 will be about getting lean: aligning investment processes and choosing alpha and index products best-suited to the drivers of return, to achieve the best outcome for clients.”
The ETF team at BlackRock predicts that while ETFs and index funds currently make up roughly 10 per cent of portfolios on average in Europe, they see this number increasing to 50 per cent over coming years.
The agents for change in this scenario are the ‘Three Ts’ – transparency, tech and tools, Marchioni writes.
1. Transparency of cost
At a time when returns are getting harder to come by, raising the level of cost sensitivity, the Markets in Financial Instruments Directive II (MiFID II) has put even greater scrutiny on value for money by mandating the disclosure of a breakdown of costs. The first client statements with detailed cost breakdowns in Q1 next year will be a crucial milestone for the European wealth and asset management industry.
Technological improvements in portfolio monitoring and risk management systems give investors greater clarity on the type of returns delivered by managers and how to most efficiently implement investment views.
The breadth, granularity and precision of investment tools has expanded rapidly over the past couple decades. For example, ETFs and index funds now encompass most of the asset classes and factors required for asset and factor allocation for the core of portfolios.
Marchioni writes that modern wealth managers have started to move from the dated siloed approach treating asset allocation, product selection and on-going monitoring separately, to a holistic model that integrates these processes.
“The output of our analysis of 500+ portfolios shows that retrofitted, siloed asset allocation models often lead to suboptimal use of fee-budget at a time when clients are focused on value for money, and / or unintended tilts and risks within the client portfolios.
“Research has long demonstrated that 90 per cent of variability in portfolio returns comes from two key areas that make up the core of the portfolio: broad market exposure and strategic factor tilts.
“Building a stronger core requires a repeatable process that is cost, risk and time efficient. This means a holistic investment model that taps into new technology to reduce friction and finding the right products that cohesively drive towards an outcome.
“Over-diversification of alpha – i.e. cancelling out positions across managers – and contradicting portfolio outcomes are common results of disjointed investment approaches.”
Marchioni writes that BlackRock is seeing investors increasingly use ETFs alongside alpha-seeking funds to trim any excess fat that is not contributing towards the intended portfolio outcome. “It’s time to move on from dated portfolio construction practices. It’s time to tap all the tools at your disposal. It’s time to get your core in shape,” she concludes.