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Fewer bonds and more alternative investments and multi-asset products: That’s what BlackRock is recommending for advisors’ client portfolios at a time when volatility remains “stubbornly high” while the pandemic continues, fiscal pressures grow and a national election looms.

“The steady hand of advisors remains critical to ensuring clients maintain focus on their long-range investment plans,” according to BlackRock’s latest Advisor Insights Guide

Following are its highlights of the guide, which is based not only on market developments but analysis of more than 20,000 advisors’ investment models from the firm’s Aladdin-powered Advisor Center and from advisors’ consultations with the firm’s Portfolio Solutions team. Interestingly, there’s no mention of environmental, social and governance or sustainable investments, which BlackRock’s CEO has been touting.

Reduce Bond Allocations

Bonds have historically served as the key diversifier for balanced portfolios, but extremely low interest rates coupled with rising equity risks have reduced their effectiveness. “Higher potential risk and lower anticipated returns is not an investor-friendly combination,” according to the Insights Guide.

BlackRock’s Aladdin platform forecasts annualized volatility of a traditional moderate 60/40 stocks/bonds portfolio above 9%, compared with 8.7% over the past five years, plus lower overall returns for both stocks and bonds.

“Bond allocations should probably decrease a bit compared to their levels in the past, when rates were higher,” the report notes.

Add Alternatives, but Beware Cost Creep 

Such additions could help portfolios better balance risk and return for the future, according to BlackRock. It recommends that advisors sell both bonds and stocks to source investments in alternatives, changing the 60/40 traditional portfolio to 50/30/20 (stocks, bonds, alternatives), rather than to 60/20/20, with allocation for bonds equal to that for alternatives.

“Don’t simply sell out-of-favor bonds,” the report says. “Source the trade thoughtfully and measure the impact to ensure the right balance of risks.”

The BlackRock report doesn’t specify which alternative investments makes sense in the current environment, but co-author Patrick Nolan, a director and senior portfolio strategist, tells ThinkAdvisor that alternatives that offer consistent and predictable non-correlation to core stocks, ideally with lower volatility, are preferred. 

Market neutral funds, for example, include products with no correlation to the S&P 500, according to Nolan. He cautions advisors, however, to do their due diligence for alternative investments because of the amount of dispersion between funds in that universe, which is much greater than that between core stock or core bond funds.

The BlackRock report also cautions about the relative higher cost of alternative investments — the average fee charged by an open-end alternative fund is 1.47% — which could affect portfolio performance. 

The remedy for that, according to BlackRock: Use low-cost ETFs for core bond and stock allocations, though the stock sleeve could be split between core stock ETF and active strategies. “A shift in this area could meaningfully help offset the cost of adding alternatives,” the report notes.

“By shifting some portfolio assets from the lower expected returns of bonds to something higher in alternatives, we can potentially overcome a more challenging market environment for clients,” according to the report. “But we must manage risk and costs while we do it.”

Add Multi-Asset Products

“This year’s volatility may prove to be a boon to multi-asset managers who navigated the pandemic well” by protecting on the downside and participating in the upside rebound, according to BlackRock.

Until the end of 2019, such funds famously underperformed — 99% failed to beat the S&P 500 on a rolling three-year period ending in each of the last seven years — and advisors generally ignored them because of the strong returns and relatively low volatility of the S&P 500 over the past decade.

But now the ability of multi-asset funds’ to protect portfolios during declines and benefit them during recoveries “makes them quite valuable in a world of moderating returns and rising volatility,” according to BlackRock.  

Comparing the performance of multi-asset funds between 2000 and 2020, using Morningstar data, BlackRock reports that they captured less than 30% of downside when the three-year average annualized return of global stocks was negative, but they captured two-thirds of the gains when the three-year annualized return of global stocks topped 7.5%.

The Current State of Advisors’ Client Portfolios 

In addition to its recommendations for advisors’ client portfolios for the future, the BlackRock report also summarized how advisors’ portfolios have changed over the past year through June 30, based on data from over 16,000 portfolios.

Advisors overall have been increasing their use of ETFs, and their aggressive portfolios continue to hold more ETFs than mutual funds for at least the second year in a row: 49.2% versus 37.9%. In conservative to moderately aggressive portfolios, mutual funds hold the majority of assets. 

Advisors have been increasing the duration of bond portfolios over the past year ended June 30, from 3.7 to 4.7, which was the biggest 12-month increase in the history of BlackRock’s analysis. 

More advisor models now blend all three types than any other combination — index, alpha and factor — and the heaviest use of factor products is in the U.S. large cap space. 

Their stock allocations are higher than a year ago, with the increase coming entirely via U.S. stocks. Non-U.S. stock allocations are flat to lower.

Among stock sectors, advisors’ portfolios continue to underweight technology — its largest underweight — but now overweight health care, which had been an underweighted sector.

Average portfolio model risks have increased by 2.2% — far more than benchmark risk, up 1.4% on average. “Importantly, the average model went from below-benchmark risk a year ago to above-benchmark risk today,” in large part because credit risk has doubled from a year ago, from roughly 30% to 60% of total bond risk, on average. 

“This does not appear the result of advisors buying a lot more credit in their portfolios, but rather the byproduct of increased credit risk in the markets,” according to BlackRock.

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