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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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3.2 ETF in this portfolio approach

With the introduction of ETFs, the use of a core/satellite strategy becomes a very practical strategy for the investor to implement. In general, investors use ETFs to control different aspect of their portfolios, to satisfy their individual investment preferences. ETFs provide a simple way to implement a professional style approach to portfolio management. In the case of this strategy, this instrument can have different functions. Even if, the main use of ETFs remains long-term buy and hold into market indices (core approach), it can act in the core and as well in the satellite.

3.2.1 ETFs in the core

According to the previous section, we can say that a low-cost diversified portfolio can easily be constructed with a few ETFs to cover the major equity asset classes and the fixed-income


market. In fact, investors use several ETFs as core position to generate low cost beta thanks to an optimal allocation between them. By consequent, they get an instant and great diversification and reduce overall portfolio risk. As well, they can only use one index ETF to get a diversified market exposure without taking stock selection decisions. The use of only one manager can reduce the cost. Thanks to the myriad of ETFs, investors can diversify risk against most of financial asset.

Moreover, the using of some ETF as the core position allows an easier rebalancing. For instance, if an investor wants to increase his equity exposure, the purchase of additional shares of an ETF makes it easy to do without having to buy additional shares for current holdings.

Therefore, ETFs can grab the same outcome than index funds in the core part of a portfolio (diversified portfolio which provides beta return). But they take an advantage over index funds thanks to their characteristics like their cost efficiency (fee, tax), their transparency, or their high liquidity. This later provides a higher handling ability than index fund.

3.2.2 ETFs in the satellite

ETFs are less suit to the satellite part because most of them are passively managed, so we can think that just produce beta and low turnover. But they can have a useful role in the satellite. Investors can use them to spread risk and enhance potential return.

ETFs in the satellite provide a better tactical overlay. Effectively, some ETFs can capture the risk premium performance of certain asset classes (e.g. value stocks). So ETFs that are not broadly diversified, such as industry sector ETF or maturity-segment ETF, can be used in a tactical way to enhance the performance of the whole portfolio. In the satellite, ETFs provide opportunities for outperformance. Moreover, ETFs have several advantages over active funds. ETFs have low turnover per year. So using ETFs in the satellite is tax effective to produce alpha. Then the active fund satellite suffers of lack of transparency, risk control and liquidity;


by introducing them, ETFs could dilute this issues. It can be a valuable added value in the portfolio regarding to the features of actively managed funds.

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