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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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4.2 Quick word on the dynamic approach

Recently, the EDHEC risk institute adapted the concept of constant proportion portfolio insurance (CPPI) to propose a dynamic way to manage a core/satellite portfolio. This later tends to tight the tracking error by investing in passive strategy (low tracking error). Therefore, investors can miss return improvement from active investment. This trend is stronger in market downturns, during which active strategies must outperform passive strategies.

The dynamic approach has the objective to avoid this deficiency through an asymmetric management of the tracking error by using a strategy to limit the underperformance of the core («bad» tracking error) while take advantage from the upside potential of the satellite («good»


tracking error). By using this approach, the managers are going to shift some allocation from the core to the satellite when this later outperforms the benchmark portfolio. On another hand, the satellite part in the portfolio decreases if the active portfolios underperform the benchmark. This approach generate always greater risk-adjusted returns than those from a static approach, with an excess return above the benchmark about twice as large in all cases 11 . Therefore, investors have to take into account this management when they are holding a core/satellite portfolio.

But the risk control benefits from this approach need consequent transaction costs due to the frequent rebalancing. This fact is likely to affect the performance of a dynamic core-satellite portfolio. So there is a trade-off between risk management and cost of trading. A less frequent rebalancing leads to a more cost-efficient management and to a likely consequent change in relative performance of the satellite with respect to the core portfolio (higher period of time). This infrequency can mitigate the result of this management by failing to get the guaranteed performance. Increasing the frequency of trading could decreases the likelihood to fail. Therefore, the presence of transaction costs is likely to be an important concern to portfolio managers.

Moreover, this approach relies on active forecasting of the future market performance, that grabs additional risk to the portfolio even if the manager is a pretty good forecaster.

Finally, the high liquidity and relatively low cost make the ETFs a natural tool to implement such dynamic strategies. They provide enough liquidity for the frequent rebalancing of this approach.

Run a dynamic approach by using ETFs could be a great option. Investors could take advantage from both : ETFs and the access to outperformance provided by a dynamic core/satellite approach.

11. N. Amenc, P. Malaise, L. Martellini, "Revisiting Core-Satellite Investing - A dynamic Model of Relative Risk Management", EDHEC-Risk institute, November 2012.


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