The Covid-19 pandemic is an unprecedented moment for global markets. Whilst short-term market volatility is something that investors are used to contend with, the current crisis-induced macro-economic outlook over the medium to long term has undoubtedly resulted in more fundamental shifts. This has prompted many investors to take a closer look at the building blocks of their portfolios. And, as they reassess their approach to asset allocation, they also find it is time to reconsider some of their long-held beliefs around portfolio construction. 
A new dawn
Over the past decade, the combination of available risk management technologies, regulation and investment tools, has contributed to creating a common view of what a typical portfolio construction approach looks like. What we found is that, over the past two years, progress among these three areas outpaced the speed at which managers adapted their day-to-day portfolio construction practices, which somehow became ‘stale’.
Whether this was linked to the active vs passive debate, manager selection processes, value for money, or the role of new factors within a portfolio, the truth of the matter is that debates, challenges and reviews around ‘standard’ approaches were long overdue.
With Covid-19, the need for a new approach is accelerating, bringing to the fore new views on how the central role of portfolio construction can deliver better outcomes for investors.
The liquidity conundrum
One area where the need for a change is most immediately apparent relates to the management of liquidity buffers. In times of unease, maintaining a sleeve within portfolios that can be easily liquidated is vital. However, holding large cash positions – a popular choice we observed in this respect during the 21 February-20 March period – can result in costly deviations from the intended asset allocation objective, which might mean missing out on potential market rebounds.
And that is why, during this period, we believe more progressive investors have turned with conviction to ETFs (exchange-traded funds) to build liquid beta sleeves. The granularity of exposures within the ETF universe provides investors with the opportunity to easily replicate their strategic asset allocation, while retaining the benefit of being invested in quickly disposable securities, should a review of the strategic asset allocation – or need for more dramatic redemptions – be triggered.
In fact, over the last couple of months ETFs have often provided efficient market access even while underlying markets have been impaired. And record trading volumes in ETFs have demonstrated the resilience of ETF liquidity amid volatility.
During the weeks between 24 February and mid-March, European ETF trading volumes surged to over twice the normal levels – from a 2019 weekly-average of $44bn, to between $110bn and $120bn across the period. On the busiest days, European ETF trading accounted for around 30 per cent of all equity trading on European stock exchanges, compared with approximately 20 per cent in the busiest days of 2019.
The value of highly liquid assets in a portfolio at times of increased volatility is difficult to underestimate. However, the proportion of such sleeves, and how they are constructed in terms of investable instruments, will depend on investors constraints and objectives. There is no one-size-fits-all approach. Yet, what remains true is that investors should seek varied return sources in cost-efficient ways depending on their specific situations, factoring in a conscious and continuous assessment of their ability to liquidate their positions.
An answer to the active vs passive debate
As a result of the ongoing crisis, and consequent large portfolio reallocations coupled with performance challenges, the ‘active vs passive’ debate has again reared its head. Some commentators argue that active managers’ potential to perform will increase, as markets become more volatile and disperse. At the same time, proponents of ETFs highlight how the current climate is only a temporary hiatus in the long-term growth trend for index funds, as for several asset classes the median active manager hasn’t exhibited materially superior performances net of fees through the turmoil.
Which side is right? In our view, neither! The characterisation of the debate in this context entirely misses the point and underestimates the potential for investors to use either strategies – index and alpha-seeking – in a holistic portfolio construction approach. At any given time – and during times of increased volatility in particular - investors need to recognise that all investment decisions are active, and that successful portfolio builders need to focus on delivering outcomes with greater efficiency and evolve their unique value proposition beyond manager selection.
The last decade has seen a seismic shift in the availability of data and, as technology continues to evolve, systematic returns will increasingly become accessible in cost-efficient manners - including through indexed strategies. We believe the result of this is a transformation of the alpha space, which allows for a greater focus on idiosyncratic returns and factor timing across the board, and allocation choices in the multi-asset space.
The role of manager selectors has moved beyond that of choosing outperforming managers, to become one progressively focused on prioritising the identification of the sources of return the investor wants to capture - and how these can be efficiently accessed through a blend of index, factor and alpha-seeking strategies.
Successful investors have started to recognise the value of expressing their long-term, market and factor choices through index vehicles, and deploying their fee budget to acquire alpha excellence from managers skilled in timing exposures and factors, and at selecting securities.
Spotlight on sustainable investing
The last few years have seen the debate around ESG move from the fringes to centre stage - and this holds true even when acknowledging that parts of the investment community continue to question if a return sacrifice is necessary when adopting sustainable investing.
We welcome this change, as we believe that a trade-off between ‘value’ (returns) and ‘values’ (investing towards a sustainable outcome) is a false dichotomy; and that sustainability already impacts the performance of all assets and, therefore, of the whole portfolio, presenting a great opportunity for superior risk-adjusted returns.
Based on this conviction, we believe we are about to see a significant step-change in sustainable investing in Europe. The coming capital reallocation, as a result of the ongoing crisis, coupled with the direct impact of climate change, and greater availability of ESG data and technology, will fundamentally reshape economic fundamentals, expected returns and assessments of risk.
Against this backdrop, we believe strategic asset allocation decisions should incorporate these implications in ways that go far beyond simply selecting sustainable products ‘here and there’ in their portfolios. As investors materially shift their allocations, they will have the opportunity to transform their whole portfolio, beyond the current tactical adoption. By better implementing ESG considerations, investors will also be able to ensure their portfolios are best positioned for the benefit of wider society, as well as to achieving the best financial return.
The current market unease poses many challenges for investors. However, it is also an opportunity to reassess long-held attitudes. As investors re-evaluate and rebalance their positions, they should question outdated beliefs around liquidity, ESG returns and active or passive management, and seize the opportunity to reconsider their long-held beliefs about portfolio construction, and build better portfolios fit to face the challenges of a rapidly evolving market environment.
Ursula Marchioni is head of BlackRock portfolio analysis and solutions EMEA. The views expressed above are her own and should not be taken as investment advice.