4 How much of the portfolio to allocate to the core vs
the satellite?
We have seen the structure of this kind of portfolio and its
benefits, and as well the fact to incorporate ETFs inside cannot be negligible.
These later have numerous added values for the core/satellite portfolio. We're
going to focus on the way to manage the portfolio. There exists two major
approaches. On one hand, the portfolio can be run statically. In this case, the
investors try to achieve an optimal allocation between the core and the
satellite, to minimize risk and maximize return. On the other hand, they can
also try to obtain the optimal allocation but by taking into account the market
performance. According to this performance, the investors is going to shift
some allocation from the core to the satellite and vice versa. This is a
dynamic management. Again, the goal to optimally allocate between the two
components is to optimize the risk and the after-tax return to may be obtain
similar risk and return than an actively managed equity portfolio, or even
better.
During the construction of a core/satellite portfolio, one of
main question which arises, is how much of the portfolio to allocate to the
core versus the satellite, or to passive versus active investment. There is no
right or wrong answer, this later depends on the objective of the investor,
both have a legitimate place in this portfolio. For instance, if an investor is
risk averse, then more proportion of the portfolio will be allocate to the core
and less to the satellite. Or it could be willing to take more risk to increase
his potential return, then the satellite part will increase in the portfolio.
Finally, the optimal allocation is driven by risk, return and correlation
between the core and the satellite.
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4.1 The static approach
This approach corresponds to a symmetric management of
tracking error by fixing allocation to the core and satellite. Again, the most
important point is to fill the investor's objective. According to BlackRock's
iShares division, a typical core/satellite portfolio is built as follow, 70% in
the core and 30% in the satellite. But according to the model of Quisenberry
and its assumptions, the optimal mix was determined to be 62% in the core; this
allocation maximizes the after-tax information ratio (excess return per unit of
risk / alpha over tracking error). The two previous sentences highlight the
fact that there is not an universal optimal allocation. But according to each
factor (risk, return) that an investor wishes to optimize to get an efficient
allocation, we can drive the allocation in an efficient manner.
The use of satellite has to be temperate : high enough to
improve the initial portfolio performance (otherwise there could have more
cost-effective strategy to obtain this return) and low enough to keep enough
liquidity which helps to fill the investor's goals. Logically, if the investor
would like to reduce the risk exposure, he needs to allocate more to the core.
According the model of Quisenberry, if core portfolio is integrated in a
satellite-only portfolio, the after-tax returns will increase. Because the
marginal benefit of adding core is more than the marginal cost of alpha
dilution. More core allocation than the optimal allocation will decrease the
after-tax return. The interaction between the core and the satellite is subject
to several dynamics, let's consider them.
The higher the after-tax return of the core, the higher the
return asked to justify an allocation in the satellite. With a satellite view,
if active managers produce a large amounts of alpha, the opportunity cost to
shift more allocation to the core is significant. That is to say, if the alpha
is high, the allocation to the core portfolio should be lower. But this dynamic
can be dilute by a
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lower correlation between the core and the satellite. This
later decreases the expected return required to justify an allocation to the
satellite.
In the same process, a lower expected volatility in the
satellite lowers the required return. In other words, if the tracking error in
the satellite increases, the core allocation should be higher.
On another hand, the allocation depends also on the total cost
of the portfolio. To get an optimal portfolio, the expensive active management
in the satellite require to increase the core allocation to offset this high
expenses.
The expected market return is also an important factor. When
allocate between the both sides, the investors or managers have to take into
account their insights about the market. If they are bullish (high expected
market return), they should increase the core part because there must be an
opportunity with the upside trend of the market and as well it's more difficult
for active manager to beat a bull market. Whereas with a bear insight, they
should increase their allocation in the satellite to enjoy the diversification
effect and so protect themselves against the market.
Finally, the anticipated changes in tax rates can influence
the final decision. If tax rates change, the dynamic in choosing the right
allocation has to take into account this tax change. The shift between the core
and the satellite can be different.
Moreover, as we have seen before, some investor can
efficiently use tax-managed core. In this case, the whole dynamic is changed
because the losses from the core help absorb the tax costs of the satellite's
gains (Tax loss harvesting). Overall, a higher expected satellite return is
required to shift a part of the portfolio from the core to the satellite.
Because if higher gains are generated in the satellite, more losses are needed
to offset this increase in tax costs. Let's take an example. I said before that
«if the alpha is high, the allocation to the core portfolio should be
lower». An increase in alpha means higher gains from the turnover in the
satellite.
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By consequent, with a tax-managed strategy, there is as well
an increase in the need for the losses from the core. Therefore, a tax-managed
core balances the dynamic in favor of the core. But the investors don't have to
increase to much the core weight, because at a precise point the benefit of
losses is not justified regarding to the capital gains from the satellite. In
one sentence, with a tax-managed core higher tax cost leads to a higher
allocation to the core.
In the real world, the return is positively correlated with
the risk. Generally, an investor wishes to have an optical allocation to
minimize the tracking error and to maximize the after tax-return. Therefore, a
good way to obtain the optimal allocation is to maximize the after-tax
information ratio as Quisenberry, which can combine the both aspect.
To sum up, with this static approach, an investor has to
carefully take into account the interaction between the satellite and the core
in terms of after-tax return and overall risk to determine the right allocation
to achieve his objectives. According to the academic researches, the optimal
core allocation is often greater than 50% but depends on several parameters,
like alpha or as well the market environment.
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