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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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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.


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


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.


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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