ETFs surge to dominant position in US model portfolios

Exchange traded funds have taken over as the dominant holding in the fast-growing multitrillion-dollar US model portfolio market, helping to turbocharge their already rapid growth.

ETFs accounted for 51 per cent of underlying assets at the end of last year, up from 46.7 per cent in early 2022, according to data from Broadridge Financial Solutions, a financial technology company, which puts the size of the US model portfolio market at $5.1tn.

“It’s certainly a milestone and [the share of ETFs in model portfolios] is only going to be going one way,” said Andrew Guillette, vice-president of global insights at Broadridge.

“There is no sense that it’s going to let up. ETFs are having tremendous success in the industry as low-cost, tax-efficient portfolio building blocks,” he added.

Model portfolios — standardised investment packages that broker-dealers, wirehouses and registered investment advisers can use to invest client money — typically use between four and 20 underlying ETFs or mutual funds to create a diversified mix of holdings.

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

“Models make sense to advisers. They help them optimise their portfolio construction to let them spend more time with clients, which ultimately is the end goal,” Guillette said.

Todd Rosenbluth, head of research at VettaFi, a consultancy, also believed the growth of model portfolios was a positive development. “It’s hard for advisers to follow all of the ETFs and all of the nuances in the marketplace, and they are often better off working with a third party to leverage their expertise,” he said.

However, the growth of model portfolios — and of ETFs within them — may add to worries over the impact they can have when they are rebalanced — potentially sending billions of dollars sloshing across financial markets.

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

The wild swings were widely attributed to iShares’ parent, BlackRock, rebalancing some of its 150-plus model portfolios.

“There was a huge outflow from ESGU and into QUAL as a result of BlackRock changing their weighting,” said Bryan Armour, director of passive strategies research for North America at Morningstar. “That led to billions moving in a single day. [However,] in most cases it is hard to track who is doing what.”

BlackRock said at the time, “as we actively manage our models to capture opportunities in the market, some ETFs included in BlackRock model portfolios experience inflows or outflows, driven by advisers who trade their clients’ portfolios in line with BlackRock’s models”.

BlackRock’s US Equity Factor Rotation ETF (DYNF) is another to be swept up by the model portfolio tide. It saw two one-day jumps in inflows on January 26 and March 15 this year, which between them added up to $4.5bn, according to data from VettaFi, more than 60 per cent of its current assets of $7.4bn.

Rosenbluth said the two dates coincided with BlackRock’s rebalancings.  

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

BlackRock said in a statement that “since the underlying securities in DYNF are large-cap US equities, and some of the most liquid stocks in 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 equity ETFs by US-based investors hit a 12-month high in February. However, rather than this being symptomatic of a broad rise in New World enthusiasm for Old World stocks, the evidence again pointed to model portfolio rebalancing.

Three-quarters of the $1bn that was pumped into US-listed European equity ETFs that month went into the JPMorgan BetaBuilders Europe ETF (BBEU), according to Morningstar data, and “JPMorgan customers own 80 per cent of those assets, so it likely stemmed from a shift in their internal portfolios,” Armour said.

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

Model portfolios appear to be growing fast. Morningstar publishes its own estimates, which it admits are “conservative” and only include third-party model providers, not broker-dealers or wirehouses.

By this measure, model portfolio assets rose 48 per cent from $286bn to $424bn in the two years to June 2023, a period during which the S&P 500 was broadly flat.  

Guillette believed this rapid pace of growth had further to run. “I think the market will grow to $11.3tn by the end of 2028 [by Broadridge’s broader measure],” he said.

The Broadridge figures suggest ETFs are unusually prominent within model portfolios. Across the US market as a whole, ETFs only account for 31 per cent of the $26.5tn held in collective vehicles.

Guillette believed ETFs’ unusually high weighting was because model portfolios were a relatively new concept, which emerged at a time when ETFs were already in vogue.

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The number of model portfolios that are built purely from ETFs has risen by 30 per cent since the first quarter of 2022, Guillette said, with the number of mutual fund-only structures falling 8 per cent over the same period.

Armour said some ETF issuers were launching products specifically because they work well as building blocks in model portfolios, encouraging their take-up.

He was, though, relaxed about the danger of ever-larger pools of assets in model portfolios destabilising either individual ETFs or the wider markets.

“One of the big trends that is occurring now is taking these core model portfolios and tailoring them for clients. It’s moving into the customisation phase which would spread some of this [trading] out,” Armour said.