You could argue that model portfolios and exchange traded funds (ETFs) go hand in hand. After all, ETFs and their broad diversification benefits have made it easy for financial advisors, institutional investors, and regular joes to build easily replicable portfolios covering a wide variety of asset classes. Together, model portfolios and ETFs have allowed investors of all sizes and stripes to meet their goals in a simplified manner.
And now, model portfolios are getting an active touch.
Several asset managers and advising groups—including BlackRock, Capital Group, and LPL —have all started to incorporate active ETFs into their model portfolios. This could be a game-changer for investors, offering higher, market-beating returns at a low cost.
Made For Each Other
When it comes to investing, asset allocation is everything. Most investors subscribe to Modern Portfolio Theory, which tells us that building a portfolio of diversified asset classes and investments leads to better outcomes. When one asset class zigs, another will zag. This smooths out returns and provides more stability to a portfolio.
Model portfolios have risen from Modern Portfolio Theory. By serving as a framework for asset allocation and diversification, model portfolios can help guide investors to stay diversified and within the bounds of the model’s guiderails. They are most effective when followed via a hands-off and rebalancing approach. This allows the model to work its magic and match risk tolerances and timelines. This keeps them invested, diversified, allocated correctly, and ultimately produces the desired portfolio returns.
ETFs have made model portfolio building easy.
Low-cost core ETFs can serve as building blocks and create a foundation, while more specialized funds can add spice and additional alpha. With ETFs as the main components, investors get simple, easy-to-follow portfolios tailored to risk tolerances and goals. Advisors like them because they make the job of portfolio construction, rebalancing, and checking on clients that much easier. The result is better outcomes for everyone.
A new report from State Street Global Advisors (SSgA) underscores the growth. According to SSgA, 39% of financial advisor assets under management are now in models, up from 32% just three years ago. Moreover, roughly 54% of advisors also use custom models, with ETFs as the main building blocks. 1
Getting Active
And now, those static and index-focused models may be getting an active touch. That’s because several heavy hitters are starting to incorporate active ETFs into their model portfolios.
Last month, iShares’ sponsor and asset manager, BlackRock, announced that its Target Allocation team, which runs portfolios for advisors and has about $150 billion in assets under management, was making a bigger leap into using active ETFs in its models. The team will buy and sell various ETFs in/out of its models as new funds are developed. This time it’s making a big splash.
The team added the actively managed iShares Bitcoin Trust ETF (IBIT), the iShares U.S. Thematic Rotation Active ETF (THRO), and the iShares High Yield Muni Active ETF (HIMU). Now, the fact that it added Bitcoin to its models is a topic for another discussion. But the addition of both THRO and HIMU is pretty significant and follows end of 2024 additions of the active iShares Flexible Income Active ETF (BINC) and the iShares Dynamic Equity Factor Rotation ETF (DYNF) to its models.
Not to be outdone, Capital Group, through its suite of ETFs and American Funds mutual funds, happens to be the world’s largest active asset manager and has now added active ETFs to eight new model portfolios. These range from Global Growth to Conservative Income. The common ingredient is they are all built using their 22 active ETFs rather than mutual funds or a combination. Dimensional Fund Advisors and advisor group LPL both have taken similar steps to build out their model capacity using active ETFs.
A Big Win For Everyone
For model portfolios, advisors, and investors, it’s easy to understand the appeal of adding active ETFs to various model portfolios.
The easy thing to see is potential outperformance. Adding active ETFs to a passive base can provide just enough ‘oomph’ to beat the benchmark and deliver better returns. The problem is that mutual funds and previously active vehicles have been expensive to own versus index funds. Most active managers can beat the market. However, those extra gains are only a few percentage points per year. Very few can crush returns. Funds’ costs come directly out of returns. If a fund charges high expenses, a manager must consistently clear that amount to generate additional returns for the fund’s shareholders. Throughout the history of mutual funds, that often hasn’t been the case, and active strategy has underperformed passive. But the lower fee hurdle of active ETFs—sometimes lower than passive funds—enables this outperformance to be realized.
The second win for active ETFs in models is taxes. In a perfect world, rebalancing would be a tax-free event, but that’s not the case. For investors using an allocation mutual fund, investors are on the hook for taxes as the fund rebalances. But thanks to their structure, ETFs are different. The secondary market and authorized participant structure allow taxes to be passed through and avoided by portfolios. Investors only pay gains tax when they choose to do so and sell their shares. As such, active ETFs are far more tax-efficient.
Finally, cash drag is eliminated. Because managers don’t have to hold cash, unless they want to meet investor redemptions or share sales, they can be fully invested in whatever assets they choose. This allows them to have better returns than a mutual fund with the same strategy. You can see this with copycat ETFs and their mutual fund sisters.
The combination of these factors is a huge win and can help drive outperformance and goal meeting. And now, some of the largest asset managers are getting hip to the benefits. By adding new active ETFs to their models, these asset managers have the ability to help investors meet better outcomes and drive real returns from their portfolios.
Ultimately, it’s a win-win for our portfolios and adds to the simplification and use of model portfolios.
The Bottom Line
Model portfolios provide a simple way to build a portfolio within a guided framework. And now, those models are getting an active touch. With several heavy hitters now adding active ETFs to their models, investors have the ability to generate better outcomes and win from an active management style.
1 FT.com (December 2024). Active ETFs will transform model portfolios, says BlackRock CFO
