BlackRock headquarters in New York. (Photo: AP)

BlackRock’s active equity overhaul that, in part, segments mutual funds into four distinct product ranges follows the same delineation approach the firm uses with its iShares exchange-traded funds.

That strategy, designed to align with specific client needs, has indeed proven successful: iShares owns the overwhelming share of the U.S. ETF market, with $1.06 trillion in assets under management of the industry’s $2.76 trillion. Globally, iShares AUM comes to $1.4 trillion of a total $3.8 trillion.

Since Donald Trump’s election to the presidency, iShares has enjoyed even stronger inflows than it captured in 2016, Heidi Richardson, head of investment strategy for U.S. iShares, told ThinkAdvisor in an interview.

Further, she discusses a handful of her current iShares investing suggestions, as well as BlackRock’s active-like smart beta strategy to enhance passive ETFs employed, for example, to minimize volatility.

BlackRock’s equity platform reorientation and just-launched Advantage series of lower-cost mutual funds has “no impact to our iShares business” right now, a BlackRock spokesperson told ThinkAdvisor.

In a September 2016 survey of U.S. investors and financial advisors, the firm found that, of the 409 FA respondents, 94% expected to use ETFs in client portfolios this year.

This past February, iShares gathered the largest net inflows for exchange-traded funds and products (ETPs) listed in Europe, totaling $3.89 billion, according to ETFGI, a research and consultancy that tracks global ETF trends.

ThinkAdvisor recently spoke by phone with San Francisco-based Richardson, who was previously a portfolio manager at Goldman Sachs Asset Management and AllianceBernstein. Here are highlights from our interview:

THINKADVISOR:  BlackRock’s survey of investors and financial advisors last September showed that ETFs will play a larger role in their portfolios in 2017. Have you noted evidence of that with iShares thus far?

HEIDI RICHARDSON: We’ve seen tremendous inflows in the last three or four months that we hadn’t seen in 2016.

Does that have anything to do with Donald Trump’s election as president, and his stated policies and reforms?

Some of it does. People are really sifting through to see which [companies] are going to be the winners and losers so they can have much more precise exposure, rather than buying our S&P 500 ETF (IVD), for example. Our U.S. Aerospace and defense ETF (ITA) has essentially doubled in assets, [as has] the area of transportation [investing], ahead of potential infrastructure spending.

iShares sells some actively managed ETFs, but you also offer funds using a strategy that enhances passive ETFs so that, essentially, they’re considered active. Please discuss.

We look at some of the exposures we have that use an active overlay as quasi-active ETFs. They fall under our Edge Smart Beta ETFs portfolio and can be used, for instance, to minimize volatility.

 What are some iShares investment ideas that you’re providing to clients?

Having an overweight position to Japan, for example, with exposure to our large-cap Japan portfolio (EWJ) or even the hedged version (HEWJ). There’s a lot of uncertainty and volatility in the U.S. and with what’s happening in the U.K. with Brexit and [in other European countries]. So, suddenly Japan looks like the most stable place around. We’re seeing a lot of capital flows back into Japan for that stability and less geopolitical risk.

What about emerging markets?

I really like ETFs in emerging markets. For broad exposure, our core portfolio, the Emerging Market Index (IEMG), is the most attractive. It gives you a minimum-volatility type of portfolio at a very low cost.

Why are you presenting these particular suggestions at this time?

The valuations are really attractive, especially as investors have been so U.S.-focused with their exposures: they’re really underweight [international and emerging markets]. In this long bull market, valuations in the U.S. have become very expensive. It’s time for investors to start thinking about diversifying outside the U.S., especially with valuations, earnings improvements and reforms in [some] countries.

What are your thoughts about using ETFs to invest in the financial sector now?

That’s a great way to do it. You can buy the broad sector, or you can be really precise and get exposure, say, to reginal banks. We’re overweight financial services and within that, we’re overweight regional banks. They’re going to benefit more in this inflationary environment and with the Fed embarking on raising interest rates.

What are the pitfalls to buying commodity ETFs?

It depends on the structure of the ETF. There are different ways to own commodity ETFs. With our gold ETF (IAU), you own shares of the physical bars of gold. Some gold ETFs out there are actually futures contracts on the price of gold. So you can be vulnerable if you don’t understand what you’re buying.

ETFs have liabilities as well as benefits, detractors say. Some maintain that ETFs caused the flash crash of May 2010. Your thoughts?

The convergence of several separate but interconnected factors led to the disruption of U.S. equity markets and ETFs at that time. The sudden equity market freefall caused market makers to have difficulty valuing ETFs’ underlying assets. The ETF industry and BlackRock, in particular, are continuing to work closely with regulatory and industry partners for market reforms to help mitigate the effects of similar events in the future.

It’s also been charged that ETFs destabilize the equity market because they don’t carry cash; and since redemptions are immediately sold into the marketplace, there’s less liquidity in the system. What do you think? I disagree about ETFs destabilizing the market. ETFs are still a fraction of what the mutual fund industry is.

Do you forecast more market volatility ahead?

Yes. As we’ve seen with the Affordable Care Act [failed effort to repeal] and some of Trump’s immigration [initiatives], it’s not a slam-dunk.  People [are] trading on animal spirts – hope and anticipation – as opposed to pure fundamentals. I think it’s going to have to go back to fundamentals: what has the best earnings growth and other factors. So, yes, you’re likely to see more volatility going forward, but that’s not necessarily a bad thing. It can create more attractive entry points for those areas that we think will do well.

Were investors trading on animal spirits right before the dot-com bust?

Yes. People get caught up in the crowd; it’s that whole concept of crowd mentality. A lot of what’s been driving this eight-year bull market run has been multiple expansion, where the price expands but there’s no improvement in earnings. However, we’ve just started to see that turn last quarter; and it’s really encouraging. It’s been called “The Trump Bump” or “The Trump Rally,” but it actually started well before [his election to the presidency]. That’s important to think about regarding the sustainability of this recovery.

What impact will rising interest rates have on investors’ decision to use ETFs?

It won’t impact the [overall] usage of them, but it will in how they choose them. In this rising rate environment, you need to be selective in your exposure because, for instance, if you own high-dividend-paying stocks, like utilities, where companies are loaded up on debt in order to finance those dividends, they’ll be much more vulnerable to cover those costs of debt.

What about rising interest rates and fixed income ETFs?

Don’t abandon your bond portfolio. But even there, you have to be selective in your exposure. It’s important to shorten up duration because the shorter the duration, the less volatility. People can also add credit exposure. So rather than just owning U.S. Treasuries, they should think about owning investment-grade credit since credit is less vulnerable to rising interest rates. You get a boost of income, and you can offset some of the volatility that might potentially increase with rising rates.

How are iShares bond ETF inflows faring?

We’ve seen tremendous flows coming into our fixed income ETFs. Historically, investors just bought an ETF as an easy way to get replication of the S&P 500, for example.

How can ETFs be used to hedge the market?

It depends on how you want to hedge. There are a lot of different ways: hedging inflation, market volatility, currency exposure or with single-country exposure, and so on. Right now, people are hedging their bets with exposure to gold in case there’s a short-term disruption where the equity markets fall off. Historically, gold is one of the lowest correlating assets to the equity market and equity-market disruption.

Your September 2016 ETF survey found that 40% of financial advisor respondents wanted to know more about ETFs’ benefits. Shouldn’t FAs be aware of these by now?

I know it sounds funny, but it depends on the business they’ve been involved in and the trading platforms they’ve used. Some of them traditionally have been doing customization with separately managed accounts. Now the trend is moving to fee-based discretionary portfolio management and managing model portfolios. So the industry has changed. Some advisors have caught the wave, and some are still doing business the way they’ve done it for the last 30 or 40 years. There’s nothing wrong with that — they just haven’t adapted.

Is using ETFs an investing strategy, or are ETFs simply vehicles for investing?

They can be used both ways. It’s not either-or. If you build a very thoughtful model portfolio for your clients with exposure to U.S. large cap and small cap, and European and Japanese markets, and emerging markets, ETFs can be a vehicle to express those views in a very low-cost, tax-efficient, liquid way. But ETFs can also be a tactical overlay of a strategy to get precise exposure to, say, regional banks or biotech, or India, as examples.

What would it take to get even more retail FAs to recommend using ETFs or use them more often?

We’re already seeing more adoption. In fact, 80% of our firm’s inflows year-to-date have come from the retail side as opposed to the institutional side. And if the Department of Labor’s fiduciary rule gets passed, there will be much more attention paid to the fees clients are paying. So advisors will want to be able to provide the best option at the lowest cost to their clients.

— Related on ThinkAdvisor: