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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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2.2.3 Consequences from the separation of Alpha and Beta

To allow an improvement of the features of a portfolio, it is vital to divide it into two elements which are managed in different way to achieve the goals of each component. I speak about the separation of alpha and beta. In other words, this is the separation of market returns and stock active managers return in evaluating performance. Beta is delivered by the core and Alpha by the satellite. This evolution can be considered as the main industry-changing in investment management.

As I said before, this division allows to avoid the long-only constraint, and by consequent to give more flexibility to managers. With the core/satellite approach, active managers can have short positions, use leverage, and they don't have to track a benchmark. The last point


allows the manager to be more focus on their primary goal of taking advantage from market inefficiencies to produce more alpha. Academic research show that the constraints from the traditional portfolio construction reduced the expected excess return, especially the long-only one7 . Moreover, the opportunity of borrowing grabs a better risk management to the portfolio. Active managers can use leverage to achieve an accurate level of risk. For instance to increase risk, they can borrow to buy more of the optimal portfolio. But the ability to use leverage has a side effect. For instance, shorting stock can have unlimited losses. The large potential downside risk mitigates the effectiveness of the risk management.

Another good point is that the distinction between passive and active strategy allows to build cost effective portfolio. Than the traditional construction portfolio, this approach needs to hire less managers (must have only one for the passive core) and is easier to monitor (less rebalancing for instance) so the associated costs are lower. Moreover, no extra money is spent to only obtain beta. This saving allows investor to spend higher active management fees in the search for «pure» alpha.

Finally, one last benefit of this approach is about the taxation. This separation put on one side the tax-inefficient trading activities and on the other side the tax-efficient benchmark tracking. So, investors can enjoy a pre-tax Beta, and is subject to tax if his active investment produces positive returns. The market exposure is not anymore subject to tax like in a traditional approach, therefore this separation allows to avoid the tax hurdle8 . This is the fact that an active manager has to produce enough excess pre-tax to offset the tax consequences of active management. The goal is the outperformance of the benchmark on an after-tax basis.

7. Clarke. Roger, Harindra de Silva, and Steven Thorley, "Portfolio Constraints and the Fundamental Law of Active Management", Financial Analysis Journal, September/October 2002.

8. Jeffrey. Robert H., and Robert D. Arnott, "Is Your Alpha Big Enough to Cover Its Taxes?", The journal of portfolio management, Spring 1993.


Moreover, this approach leads to less turnover events (e.g. infrequent rebalancing), by consequent the incidence of tax decreases.

One more thing about the taxable environment, the core can be tax managed. The tax-loss harvesting strategy has to be applied. That consists to sell benchmark stocks that have decrease in value while keeping those that have appreciated. The short- or long-term losses from the sales can be netted against gains from satellite portfolios. Therefore, the investors can absorb some capital gains tax liability. The use of this strategy allows to get a higher after-tax return than a non-tax managed core. To implement this strategy, an investor has to have a willingness to sell stocks which do not perform well, and a willingness to hold appreciated stocks. Note that this strategy can be run while keeping a low tracking error versus the benchmark.

Overall, the separation of alpha and beta allow the active manager to create higher return per unit of tracking error.

This division has not only good side effects. Now, active managers have only one goal. But in the traditional portfolio construction, the benchmark constraint allowed to monitor their behavior; they needed to have a broadly diversified portfolio to get beta. So this evolution gives some freedom in the large amount of investment possibility to the managers, and takes some control from the investors.

Furthermore, Investors can have some difficulty to get information about his active holding. Because some component of the portfolio like hedge funds, does not report frequently the portfolio holdings and their results. The investors can lose some transparency with this approach.

Another point states that some investment of the satellite portfolio are blocked for a long period of time. For instance, hedge fund can require investors to stay in the fund during a


minimum period of time, like one year. So an investor can see his portfolio liquidity decreases with a core/satellite approach.

We can see that the benefits from this separation largely overcome the side effects. By taking into the previous points and the need of a new alternative in portfolio construction, we can expect that this approach is pretty used in the financial world.

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Bitcoin is a swarm of cyber hornets serving the goddess of wisdom, feeding on the fire of truth, exponentially growing ever smarter, faster, and stronger behind a wall of encrypted energy

"I don't believe we shall ever have a good money again before we take the thing out of the hand of governments. We can't take it violently, out of the hands of governments, all we can do is by some sly roundabout way introduce something that they can't stop ..."   Friedrich Hayek (1899-1992) en 1984