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

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

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2.2 The features of this approach

The core-satellite strategy allows to match the portfolio to the client's risk aversion, like traditional approaches. The whole portfolio is managed to be efficient in a taxable client's three-dimensional space : return, risk and taxes. The basement of this approach is to drive the portfolio in specific directions, or to control its performance as it is impacted by the three previous factors. This method is designed to minimize costs, tax liability and volatility while

5. William R. Thatcher,«When Indexing Works and When It does not in U.S. Equities : the Purity Hypothesis", 2009


providing an opportunity to outperform the broad stock market as a whole. The core-satellite approach must produce long term wealth creation. This strategy is based on asset allocation which is the main driver of long-term performance; that explain 94% of the movement in portfolio returns6 .

2.2.1 What about the core?

The core of the portfolio consists mostly of passive investments that track the performance of major market indices like the S&P500 in the US or the CAC40 in Europe. By following such indices, it is a cap-weighted portfolio. Its goal is to generate beta; it should not generate performance alpha. Note that Beta is the performance delivered by the market and Alpha is the performance delivered by a manager over and above what the market delivers.

A Passive managers will purchase investments with the intention of long-term appreciation and limited maintenance. By consequent, low fees are expected for this kind of portfolio manager. So the core portfolio should be relatively inexpensive. The most appropriate core is a broadly diversified portfolio, built with ETFs, Index Funds, or tax-enhanced index. It should take a long-term view with rebalancing maybe once per year. A tax managed core allows to increase the after-tax return. Regarding to the low turnover and the low gain realization provided by a passive management, the core is as well tax efficient. Note that it can be improved if it is tax managed by using a tax-loss harvesting strategy. That is to say the ideal core strategy depends on the investor's overall tax situation. We're going to speak about that in another section.

2.2.2 What about the satellite?

The satellite positions are added into a portfolio by taking into account the goals of the investor and the investor's tolerance for risk and illiquidity, time horizon, and non-transparency. This part of the portfolio is in the form of actively managed investments, several portfolios

6. Roger G. Ibbotson, Paul D. Kaplan, "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?", 2000.


of active manager. This kind of manager are aggressive alpha seekers with fewer investment constraint, they continuously monitor their activity in order to exploit profitable conditions across multiple markets (market inefficiencies). In other words, they allow to get access to active risk strategies that have an attractive expected return. So to choose a specific satellite strategies, an investor must be considered the return to active risk offered by each strategy. Managers implement different strategies according to the market capitalization and the style (e.g. mid-cap value) to mostly produce long term gains. The satellite components can be a «concentrated» long short equity portfolio, private equity or hedge fund (market neutral one). Unlike the core, the satellite is not tax efficient because of its possible high turnover and capital gains. Even of this tax inefficiency and high fees, an investor is willing to pay for active strategy to get alpha. Finally, managers must have to cover taxes and fees, so they must produce enough excess return.

The satellite part is independent of the core part, that is to say exhibits a low correlation with the benchmark. So the diversification level of the portfolio increases. This fact enhances the total performance consistency, especially in down markets.

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