The potential benefits of blending active and index

_{By: BlackRock}

Discussions of active and index investing shouldn’t be about picking sides. That’s just not what investing is about – investing is as much about what works together as what works best.

We want to demonstrate how active and index exposures can do different jobs in a portfolio, in this instance a high yield bond portfolio. Far from being in competition – active and index can be complementary.

What an index investment can bring to your high yield portfolio

High yield has always been seen as a relative value asset class, one that requires experienced active management. But combining your active investments with an exchange traded fund (ETF) could provide flexibility and diversification, and even helps to lower costs.

Liquidity brings flexibility

Flexibility can be found in the liquidity ETFs offer – asset allocation decisions can be executed swiftly and at scale. It could be a powerful tool, in that it allows you to change your broad market exposure – your investment in 100s of bonds – in one trade.

Easy to establish factor tilts

When it makes sense to gain access to more granular factors, ETFs can allow us to do this too. Certain ETFs let investors access specific fixed income sectors, difference credit quality tiers, duration buckets and sustainable strategies.

More accurate market timing

With an ETF, it’s also far easier to time your exposures and rotate across markets or adjust your risk as you see opportunities and/or volatility coming down the track. When markets are as changeable and yields as low as they are right now, this can be a vital tool to have at your disposal.

What an active allocation adds

If we are using index investments to efficiently access broader market forces, where does that leave the search for alpha?

Active management remains the route to alpha

Alpha is the prize we seek for taking the risks inherent in a higher-yielding sector. For this we require security selection. Although allocating to an index gives us exposure, we are not taking advantage of relative value opportunities. Capturing these opportunities is even more important at a time when carry trades are unlikely to be all that profitable in the months ahead. Yields are meaningfully lower and credit spreads are generally tight, so we need experienced active managers to deliver excess returns.

How active and index can work together

In summary, combining ETFs and active management is all about balancing the key sources of a portfolio’s risk and return.

Because high yield can be both profitable and volatile, when and how we invest is of particular importance, making it the ideal asset class for blending active and index exposures.

First of all, we need to be as nimble and flexible as possible, so including a high yield ETF as part of a core or tactical high yield portfolio can provide diversification, help navigate volatile markets through asset allocation and protect capital when active performance is challenging.

Secondly, controlling wider exposures through ETFs allows us to take advantage of volatility and seek alpha in the active part of the portfolio.

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