A core-satellite management consist in having a core portfolio made up of passive management vehicles (index funds, ETFs, etc.) with low management fees, and separately one, or several, very active satellites that are made up of funds with a strong tracking error, or even funds with no constraint whatsoever on managing relative risk with regard to a benchmark (hedge funds, for example). The purpose of the core component is to control management risks and to improve the efficiency of the overall portfolio by limiting costs. The role of the active components is to provide diversification and to generate out-performance. The core-satellite portfolio model was adopted by institutional investor's years ago. However, the wish to improve the investment efficiency after the adverse market conditions of the early 2000, have helped the move to this strategy during the past years.
[...] The biggest providers: Barclays Global Investors, State Street and Vanguard, by far were well established as big providers of passive investing for mutual funds and pension funds. What kinds of ETFs exist? There are many available ETFs that attempt to track all kind of indexes (such as large-cap, mid-cap, small-cap, etc), specialties (such as value and growth), industries, countries, precious metals and other commodities or commodity indices like GSCI; and more are being developed for the future. Based on EDHEC Risk and Asset Management Research Center's survey by 2004 to European institutional investors and asset managers, the responses reflected the geographical ETFs as a useful tool for both the core and satellite approach. [...]
[...] They can also be used in the satellites to remove the systematic exposure from a long strategy and create a portable alpha component. By identifying the best hedge, the beta exposure is neutralized by taking a short position in an ETF. Core-satellite strategies can be a solution, which generate alpha while preserving benefits of ETFs. While the core delivers the index performance at a moderate expense ratio, the satellites are investments that search for alpha. Diversification and de-correlation can be calibrated as needed to obtain the client's desired risk level. [...]
[...] growth spread, implied volatility, etc.) or bond market (term spread, credit spread, bond returns volatility, etc.) Other “alternative” beta benefits (commodity price levels, currency rates, etc.) The two last beta types increase the possibilities of risk-taking for the investors. Capitalize on hedge funds betas: the two approaches There are two approaches to capitalize on hedge fund beta. These strategies, though they are opposed, can both lead to a significant improvement in risk-adjusted performance and use hedge fund indices as allocation tool. [...]
[...] Furthermore, in the absence of tracking error constraint the hedge fund managers can fully exploit their talent and therefore produce higher information ratio. Sources of alpha Security selection Timing the exposure to various risk-factors The hedge funds have a privileged place in the satellite today. Indeed they are very active and generate alpha which is exactly what is expected for a satellite. Furthermore, as we have seen, they have a low correlation with the risks of traditional asset classes, therefore a hedge fund portfolio can be easily ported onto a different portfolio. [...]
[...] In order to keep a low tracking error for the global portfolio while increasing the tracking error of the satellite, it is important to keep the core as close as possible to the benchmark. Here, the objective of this benchmark is not to track an index but to define the risk and return properties the investor considers optimal over a long horizon. It is the long-term beta exposure that the manager wants to have. The risk/return profile desired by the investor typically depends on his liabilities and/or risk preferences. [...]
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