ETFs gain dominance in US model portfolios

Exchange-traded funds have become the dominant position in the rapidly growing multibillion-dollar U.S. model portfolio market, helping to fuel its already rapid growth.

ETFs accounted for 51 percent of underlying assets at the end of last year, up from 46.7 percent at the start of 2022, according to data from Broadridge Financial Solutions, a financial technology company, which estimates the size of the American model wallet market at $5.1. tn.

“It is certainly an important step and [the share of ETFs in model portfolios] it’s only going to go one way,” said Andrew Guillette, vice president of global insights at Broadridge.

“There’s no sense that it’s going to stop.” ETFs are enjoying huge success in the industry as low-cost, tax-efficient portfolio building blocks,” he added.

Model portfolios – standardized investment packages that broker-dealers, wire companies and registered investment advisors can use to invest clients’ money – typically use between four and 20 underlying ETFs or mutual funds to create a diverse mix of titles.

They are designed to form the core of an investor’s portfolio by targeting a specific level of risk.

“The models make sense to advisors. They help them optimize their portfolio construction to allow them to spend more time with clients, which is ultimately the end goal,” Guillette said.

Todd Rosenbluth, head of research at VettaFi, a consultancy, also believes the growth of model portfolios is a positive development. “It’s difficult for advisors to keep track of all the ETFs and nuances of the market, and it’s often better for them to work with a third party to leverage their expertise,” he said.

However, the growth of model portfolios – and the ETFs they contain – may add to concerns about the impact they can have when rebalanced – potentially sending billions of dollars into financial markets.

In March 2023, the iShares ESG Aware MSCI USA ETF (ESGU) hemorrhaged $3.9 billion in one day. On the same day, the iShares MSCI USA Quality Factor ETF (QUAL) saw a $4.8 billion increase in net inflows.

The wild swings were largely attributed to iShares parent BlackRock rebalancing some of its more than 150 model portfolios.

“There was a huge outflow from ESGU to QUAL following the BlackRock weighting change,” said Bryan Armour, director of North America passive strategies research at Morningstar. “This made it possible to move billions of people in a single day. [However,] in most cases it is difficult to know who is doing what.

BlackRock said at the time: “While we actively manage our models to capture market opportunities, certain ETFs included in BlackRock model portfolios experience inflows or outflows, led by advisors who trade their clients’ portfolios in accordance with to BlackRock models.”

BlackRock’s US Equity Factor Rotation ETF (DYNF) is another to be swept up in the tide of model portfolios. It saw two one-day surges in admissions, on January 26 and March 15 of this year, which between them totaled $4.5 billion, according to VettaFi data, or more than 60%. of its current assets of $7.4 billion.

Rosenbluth said both dates coincided with BlackRock’s rebalances.

As a result, he said anyone considering buying DYNF should be aware that “most of the money is tied up in BlackRock’s model portfolios, and if BlackRock chooses to reduce exposure to this ETF, then the assets could begin to dissipate and the ETF’s on-screen liquidity could be hampered.

BlackRock said in a statement that “because DYNF’s underlying securities are large-cap U.S. stocks and some of the most liquid stocks on the market, liquidity was not a challenge when the fund was added to the model portfolio. At a minimum, an ETF will be as liquid as its underlying securities.

In another example, purchases of European stock ETFs by U.S.-based investors hit a 12-month high in February. However, rather than being symptomatic of widespread New World enthusiasm for Old World stocks, the evidence once again pointed to a rebalancing of model portfolios.

Three-quarters of the $1 billion pumped into U.S.-listed European stock ETFs that month was invested in the JPMorgan BetaBuilders Europe ETF (BBEU), according to Morningstar data, and “JPMorgan clients own 80% of these assets, so it is likely that stems from a change in their internal portfolios,” Armor said.

According to Morningstar data, JPMorgan is only the eighth third-party provider of model portfolios in the United States, a market dominated by BlackRock and Capital Group, followed by index providers Wilshire Associates and Russell Investments.

Model portfolios appear to be growing rapidly. Morningstar publishes its own estimates, which it admits are “conservative” and include only third-party model providers, not brokers or wire companies.

By this measure, model portfolio assets grew 48%, from $286 billion to $424 billion in the two years to June 2023, during which time the S&P 500 remained broadly stable.

Guillette believed that this rapid pace of growth was expected to continue. “I think the market will reach $11.3 trillion by the end of 2028. [by Broadridge’s broader measure],” he said.

Broadridge’s figures suggest that ETFs occupy an unusually large place in model portfolios. Across the entire US market, ETFs represent only 31% of the $26.5 trillion held in collective vehicles.

Guillette believes that the unusually high weighting of ETFs is because model portfolios are a relatively new concept, appearing at a time when ETFs were already fashionable.

The number of model portfolios built solely from ETFs has increased 30% since the first quarter of 2022, Guillette said, with the number of structures comprised solely of mutual funds declining 8% over the same period.

Armor said some ETF issuers are launching products specifically because they work well as building blocks in model portfolios, thereby encouraging adoption.

He was relaxed, however, about the danger that ever-larger pools of assets in model portfolios could destabilize either individual ETFs or broader markets.

“One of the big trends right now is tailoring these core model portfolios to customers. We move on to the personalization phase which would make it possible to disseminate part of this [trading] outside,” Armor said.