There is a lot to consider when building a portfolio. First and foremost, what is the end goal? Beyond that, investors need to also consider how much risk to take and over what time horizon? Another question that frequently comes up and is the source of many contentious debates: Should I consider indexed or active products? The simple and important answer is: both.
Blending index and actively managed funds may make a better portfolio—meaning there is a greater chance that the portfolio may deliver a higher risk adjusted return. The challenge is how to combine them in a manner that is most likely to deliver on the portfolio objective. The topic of index versus active has filled countless academic journals and textbooks, but we think a good example of how to go about this in the real world to help investors meet their goals can be found in the BlackRock Model Portfolios.
First, some background. The BlackRock Model Portfolios are a series of asset-allocation models that are intended as tools to help financial advisors design an investment strategy for their clients. The models can be used for pursuing different financial goals, like saving for the longer term or seeking income. The models come in two forms: exchange traded fund (ETF) only, and models that use both ETFs and active mutual funds.
The process begins with the stated goal or goals, such as: Are we attempting to deliver total return or income, and with what constraints? Next is the question of the opportunity set. Ideally, we want to use as broad of a set of investment vehicles as possible, looking across asset classes, investment styles and geography. The reason for this is because we are trying to combine assets and instruments that have a low, or in the perfect world, negative correlation. This helps ensure sufficient diversification. Using a proprietary risk management system, we go beyond looking at historical performances of active funds and ETFs and focus on their underlying securities and the market risks that they are exposed to. Whether they are interest rate, credit or equity risks, understanding the different exposures allows us to manage and seek to reduce risks.
The arguments for including active funds is the potential for excess returns, known as alpha. When managers make bets relative to a benchmark, they are taking an active risk and, if a manager is correct, he should be rewarded for taking those active risk bets. However, investors should always keep in mind that it may not be enough for a manager to simply produce excess returns. The alpha should be large enough to compensate for both the extra fees as well as the added risk.
In deciding which active funds to include, we tilt toward those mandates that allow the manager maximum latitude. In other words, we favor less constrained, high breadth mandates that allow the managers to go anywhere in the world because that flexibility allows them to put their skills to work over a broader universe of investments.
The BlackRock Global Allocation Fund (MALOX) is one example of such a strategy. It aims to produce a similar level of return as a broad equity fund with less risk, which can help us keep the overall risk in our portfolios manageable. For example, a balanced portfolio consists of 60% equities (as represented by a broad equity index, such as the MSCI All Country World Index) and 40% bonds (as represented by the Barclays Capital Aggregate Bond Index). By adding this fund, we are able to construct a portfolio with the risk level ––in other words, the volatility one would expect––closer to what you’d normally expect to see in a portfolio that contains 50% stocks and 50% bonds. This may allow a more conservative investor to achieve higher returns while still staying within his or her comfort zone.