Active or passive? That’s often the starting point when investors and their advisors decide how to allocate assets when constructing portfolios. It may be the wrong question to ask.

“Looking at portfolios through an active versus passive lens misses the big picture,” says Kurt Reiman, BlackRock’s Chief Investment Strategist for Canada. “No portfolio is passive, and active returns can come from many different sources. At BlackRock, we believe a better approach is to blend different sources of return in cost-efficient ways. To do that, it’s important to take a step back and tease out the portion of a portfolio’s return that can be effectively captured by rules-based indices, such as broad market and factor-based exposures, and those that flow from alpha-seeking strategies.”

Traditional, cap-weighted broad market index strategies are well understood. They offer a combination of low-cost diversification, consistent market exposure and transparency in holdings that makes them highly efficient building blocks for today’s portfolios. Less widely acknowledged is the significant component of a portfolio’s return that is systematically captured through factors. At BlackRock, we focus on two major factor groupings: macro and style. Macro factors – economic growth, real rates, inflation, credit, emerging markets and liquidity – offer returns across asset classes and describe movements of whole markets. Style factors, such as value, momentum, carry, low volatility, quality and size, offer returns within asset classes, capturing the relative movements of securities within markets.

Factors – the broad, persistent drivers of return across and within asset classes – are more accessible and affordable than ever thanks to new technologies and expanding data sources. Smart beta strategies target factors using a rules-based approach, usually with the goal of outperforming a market-cap weighted benchmark – and are now widely available in ETFs. Financial advisors can use smart beta strategies as complements to traditional index funds to build affordable portfolios that deliver excess return and reduce risk.

Yet the returns of alpha-seeking investments can also be driven by factors – and it’s important to assess the role that factors play. By breaking down what share of alpha-seeking returns stem from factors, advisors can examine whether managers are delivering unique sources of alpha that cannot be derived from lower-cost factor strategies.

“Portfolio management means a lot more than security selection,” says Reiman. “It’s how you combine index, factor and alpha-seeking strategies. It can encompass asset allocation, portfolio construction and tax management strategies. Designing a portfolio around clients’ needs – based on their objectives and liabilities – can deliver as much value to investors as the time spent finding and monitoring alpha-seeking managers.”

That suggests every portfolio is active – and advisors are increasingly architects designing portfolios from ever-more sophisticated investment building blocks.

“Understanding the sources of returns helps advisors build diversified portfolios that don’t cost clients more than they’re worth. Where it’s possible to access the exposures you want through index and factor strategies, do it. Then use more expensive alpha-seeking strategies to achieve specific portfolio objectives,” suggests Reiman. “This approach is likely to become a necessity, not a nice-to-have, as advisors move towards a fee-based, discretionary model.”

Watch for the next article in this series, focused on how to use indexing strategies to build a well-designed portfolio core.

This article is prepared by BlackRock and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.