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Efficient way to build a core-satellite portfolio by using exchange-traded funds

par Vincent LLOVIO
Université Toulouse Capitole 1 - TSE - Master 1 in Economics 2016

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Efficient way to build a Core-Satellite Portfolio by using Exchange-Traded Funds

Vincent Llovio, Master 1 in Economics
Advisor : Milo Bianchi
Toulouse School of Economics
June 15, 2016


Table des matières

1 Introduction 4

2 The core-satellite approach, what is it ? 5

2.1 Born from the failure of traditional portfolio construction 5

2.2 The features of this approach 7

2.2.1 What about the core? 8

2.2.2 What about the satellite? 8

2.2.3 Consequences from the separation of Alpha and Beta 9

2.3 One last word! 12

3 ETF, a young financial instrument 12

3.1 An ETF, what is it? 12

3.2 ETF in this portfolio approach 14

3.2.1 ETFs in the core 14

3.2.2 ETFs in the satellite 15

3.3 One last word! 16

4 How much of the portfolio to allocate to the core vs the satellite? 17

4.1 The static approach 18

4.2 Quick word on the dynamic approach 20

5 Conclusion 22

6 Appendix 23

7 References 23

7.1 Academic references 23


7.2 Online references 24


1 Introduction

Initially, the construction portfolio was based on the modern portfolio theory (1952). This concept through strategic and tactical asset allocation tries to optimize the risk and the return of the portfolio with an active management by taking into account the financial goals and the risk tolerance of the investor. During 64 years, the financial environment has progressed and the financial agents (academic and professional) have gained experience from the past. So inevitably during those years, new concepts, new behaviors arose in the financial market. An alternative to the modern portfolio theory no tends to appear, the core/satellite portfolio construction.

This approach is an old concept which has seen its popularity suddenly raised because new investment vehicles appear to improve this later, like Exchange-Traded Fund. This strategy is based on asset allocation which is a pretty important point to take into account, to expect earn consequent portfolio return. This approach divides the portfolio in two parts, the core and the satellite. The core must provide a beta exposure and the satellite aims to get an alpha return. By consequent, the core is passively managed whereas the satellite is actively managed. This strategy has the same goal than the modern portfolio theory.

This new investment vehicles, called ETFs, was created in 1993. It combines the advantages of both index funds and stocks. In other words, it allows to get a market exposure with a certain liquidity. It permits to achieve diversification against narrow segment of the market. That's one of the reasons that this instrument improves the core/satellite approach.

Recently, this later and the core/satellite strategy have seen their popularity raised. Therefore, the academic research about these two elements is pretty large. The EDHEC risk institute has a large research chair which works on both. Consequently, there are updated and consistent documents about these subjects.


In my analysis, I'm going to consider only the taxable investors, and not the institutional investors. Note that to get a positive outcome from this strategy, it's crucial to implement it optimally. Therefore, one question arises : How to take the best side of the core/satellite approach by using ETFs?

I'm going to divide my analysis in three parts. Firstly, I'm going to provide some background of this approach. What are the benefits/disadvantages? Why should we see this strategy to emerge? Secondly, I'm going to focus on the ETFs and their role in this approach. Finally, I'm going to try to answer the following question : how much of the portfolio to allocate to the core vs the satellite?.

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