How To Build A Balanced Portfolio For Today’s Market

The markets have changed a lot since the financial crisis and the global wave of monetary easing that followed. In the wake, advisors everywhere have found that building balanced portfolios isn’t so easy anymore, as traditional models such as 60/40 fall short of investor needs. Martin Small, head of BlackRock’s iShares, talks about the challenging environment, and tells us how to build a solid portfolio with a keen eye on that tricky fixed-income allocation.  

ETF.com: Is the challenge of building a balanced portfolio any different today than it was before we had, say, 1,900 ETFs to choose from? Is building a portfolio more difficult today?

Martin Small: There's never been more choice in the ability to blend broad-market core ETFs at extremely attractive value with precision exposures like preferred stock ETFs or currency-hedged Japan ETFs. There’s a vast array of tools that advisors and self-directed investors can use today to build any portfolio with any risk/return characteristics they want.

That said, there have been, over the better part of the last decade, permanent alternations in the contours of global equity and global fixed-income markets that have made portfolio construction harder than it used to be.

The traditional 60/40 portfolio, which has always been a good starting place, is expected today on most capital markets' assumptions to return somewhere between 2-3%, to a high of 4-5%. That's dramatically different from the environment that my parents grew up in, where they were able to use a traditional 60/40 balanced portfolio not only as a starting place but as a great way to grow wealth for the long term.

What's really changed—and what poses some of the larger portfolio construction challenges—is a decade of monetary policy that’s been unusual and particularly aggressive, and has distorted the fixed-income landscape. And fixed income is where advisors are having the greatest challenges. They've forgotten why they own fixed income.

We’ve pushed global yields so low as a result of aggressive monetary policy that people forget that they own fixed income not just for income, but for safety and diversification—safety as in surety of principal, something that is money good; diversification, bond ballast for your equities, as something that’s supposed to zig when the S&P 500 zags. And, finally, income.

Most advisors have inverted that pyramid. Safety should be the biggest part of your fixed income, followed by diversification, followed by income. Most people, as a result of an extremely low-yield environment, have emphasized income over diversification and safety. That permanently altered the landscape for how people are building portfolios.

ETF.com: Does that mean advisors are taking on too much risk on the fixed-income sleeve in the pursuit of income?

Small: We did more than 1,000 portfolio consulting engagements with advisors over the course of the last year or so. We found that 90% of conservative portfolios are riskier than the benchmark; 80% of moderate portfolios are riskier than the benchmark; and 70% of aggressive portfolios are riskier than the benchmark. There's a reason for that. It's both in equities and in fixed income.

In equities, strategies that are benchmarked to traditional benchmarks like the S&P 500 or the Russell 1000 are taking more risk in, let's say, concentrated stock positions or in market timing and turnover than the benchmark. As a result, there's more risk in the equity book than the benchmark would suggest.

In fixed income, as a result of the desire to increase yields and current income on a portfolio, there's a greater presence of fixed-income assets that are correlated to equities, like high yield and more down-in-credit strategies.

I think the fixed-income part of the book has been more challenging because of the massive distortions that have come from global quantitative easing. Equities have largely been the beneficiary of those actions.

ETF.com: When you're building a portfolio, what's more important when you're deciding on your asset allocation: a focus on what's driving returns or on risk management?

Small: They go hand in hand. Every part of an asset allocation should ideally ask: “Why is it there? What is the purpose of that wedge in the overall pie of the asset allocation? Is it there to provide growth? Is it there to provide downside protection? Is it there to provide income? Or is it there to provide stability of principal?” The asset allocation needs to consider the expected risk/return of each of its components.

That's what's always been a terrific feature of ETFs—because they track an index, they have, ex ante, a known and understood and transparent risk/return profile. When I buy the Russell 1000 ETF, I know I'm getting the risk/return characteristics of the Russell 1000 ETF. I'm not getting somebody's riff on what the Russell 1000 should be.

Being able to build portfolios with individual building blocks that have known risk/return characteristics is where we're headed from a portfolio construction standing. As a result, ETFs will play a major part in how people shape portfolios going forward.

ETF.com: If 60/40 is no longer an ideal portfolio, is there a recipe for building a good balanced portfolio?

Small: I keep a balanced portfolio on my desktop, and I always look at a 60/40 portfolio. Mine's pretty basic. It's the iShares Core S&P Total U.S. Stock Market ETF (ITOT) at 0.03%; it's the iShares Core MSCI Total International Stock ETF (IXUS), which includes EAFE and EM; and it's the iShares Core U.S. Aggregate Bond ETF (AGG).

That’s the lowest-cost portfolio in the industry. And it's the one I keep on my desktop, because every time I think I have a better idea about how to beat it, I have to keep that reminder that actually it's a really good portfolio.

The thing is, as I think about the different investment objectives I have, I have some places where I need more current income than a 60/40 would provide. In some places, I'm trying to save for my kids' college; I need more than 3% growth to actually hit the expected cost of tuition.

The first place I always start is not with what the products are and what the return characteristics are. I start with the objective-setting, which is to really think through what is my growth portfolio, what is my income portfolio, and what is my rainy-day portfolio, where I really care about the stability of principal. And then I build individual building blocks around each one of those.

I find that the best advisors in the best practices build portfolios that way; which is, they start first and foremost with good objective-setting with their clients. And once you have good objective-setting, it becomes much easier to optimize for the other two things, and decide on the right mix of products.

Finally, you have to allocate a cost budget, which is, how much am I willing to spend on it, and what are the after-tax characteristics of that portfolio? That often pushes advisors to have more ETFs.

ETF.com: How do you know when your portfolio is off-balance, when your mix isn't right?

Small: I see an increasing focus on two ways of building and monitoring great portfolios. The first I would characterize as those who have done a great amount of work on asset allocation and portfolio construction, from the start. They want to minimize tracking error to the benchmarks they've picked for each asset class.

At that point, they focus on whether the asset allocation is working the way they thought it would work. Are the bonds in there for diversification and income actually providing diversification and income? Are correlations right? I’d call them the tracking error-focused portfolio manager who believes in the asset allocation.

The second group of investors doesn't really care about tracking errors so much, they care about outcomes. These are investors who are increasingly embracing smart beta and noncap-weighted strategies.

For example, they want to realize the market return over a full cycle but with less volatility. So they are willing to take more tracking error to the S&P 500 in a one-year or two-year period if they get less volatility. What they want to know is, am I tracking toward my outcome?

ETF.com: With so many ETFs to choose from, is there ever a risk of being too diversified?

Small: I used to think there were too many different flavors of ice cream, and then I tried black raspberry chocolate chip and it was absolutely delicious. The truth is, investors are more discerning than we often give them credit for.

Most of the assets in the ETF industry are concentrated in the top 100 funds that are the biggest, broadest market exposures and the most liquid and tax-efficient. I think investors generally get this right, which is that the core building blocks of any asset allocation—U.S. equities, international and EM equities and basic core bond—those are the places that are growing fastest in the ETF industry because they're at the heart of portfolios.

More choice benefits investors. As long as they're guided by the basic tenets of portfolio construction—which is great objective-setting, thinking about that mix of stocks, bonds, active, index, and then focusing on managing the total cost of ownership and tax—they generally get it right.

Contact Cinthia Murphy at [email protected]