Efficient way to build a core-satellite portfolio by using exchange-traded funds

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Dissertation

Efficient way to build a Core-Satellite Portfolio by using Exchange-Traded Funds

Vincent Llovio, Master 1 in Economics
Advisor : Milo Bianchi
Toulouse School of Economics
June 15, 2016

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Table des matières

1 Introduction 4

2 The core-satellite approach, what is it ? 5

2.1 Born from the failure of traditional portfolio construction 5

2.2 The features of this approach 7

2.2.1 What about the core? 8

2.2.2 What about the satellite? 8

2.2.3 Consequences from the separation of Alpha and Beta 9

2.3 One last word! 12

3 ETF, a young financial instrument 12

3.1 An ETF, what is it? 12

3.2 ETF in this portfolio approach 14

3.2.1 ETFs in the core 14

3.2.2 ETFs in the satellite 15

3.3 One last word! 16

4 How much of the portfolio to allocate to the core vs the satellite? 17

4.1 The static approach 18

4.2 Quick word on the dynamic approach 20

5 Conclusion 22

6 Appendix 23

7 References 23

7.1 Academic references 23

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7.2 Online references 24

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1 Introduction

Initially, the construction portfolio was based on the modern portfolio theory (1952). This concept through strategic and tactical asset allocation tries to optimize the risk and the return of the portfolio with an active management by taking into account the financial goals and the risk tolerance of the investor. During 64 years, the financial environment has progressed and the financial agents (academic and professional) have gained experience from the past. So inevitably during those years, new concepts, new behaviors arose in the financial market. An alternative to the modern portfolio theory no tends to appear, the core/satellite portfolio construction.

This approach is an old concept which has seen its popularity suddenly raised because new investment vehicles appear to improve this later, like Exchange-Traded Fund. This strategy is based on asset allocation which is a pretty important point to take into account, to expect earn consequent portfolio return. This approach divides the portfolio in two parts, the core and the satellite. The core must provide a beta exposure and the satellite aims to get an alpha return. By consequent, the core is passively managed whereas the satellite is actively managed. This strategy has the same goal than the modern portfolio theory.

This new investment vehicles, called ETFs, was created in 1993. It combines the advantages of both index funds and stocks. In other words, it allows to get a market exposure with a certain liquidity. It permits to achieve diversification against narrow segment of the market. That's one of the reasons that this instrument improves the core/satellite approach.

Recently, this later and the core/satellite strategy have seen their popularity raised. Therefore, the academic research about these two elements is pretty large. The EDHEC risk institute has a large research chair which works on both. Consequently, there are updated and consistent documents about these subjects.

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In my analysis, I'm going to consider only the taxable investors, and not the institutional investors. Note that to get a positive outcome from this strategy, it's crucial to implement it optimally. Therefore, one question arises : How to take the best side of the core/satellite approach by using ETFs?

I'm going to divide my analysis in three parts. Firstly, I'm going to provide some background of this approach. What are the benefits/disadvantages? Why should we see this strategy to emerge? Secondly, I'm going to focus on the ETFs and their role in this approach. Finally, I'm going to try to answer the following question : how much of the portfolio to allocate to the core vs the satellite?.

2 The core-satellite approach, what is it ?

2.1 Born from the failure of traditional portfolio construction

The modern portfolio theorem (MPT) and the capital asset pricing model (CAPM) indicate that return and risk are positively correlated and as well that a portfolio should be diversified in its sources of risk. Based on the MPT, the common approach to build a traditional portfolio is to take a long-term view by hiring active portfolio managers to implement allocations to stock or bond markets, with a diversification objective. The active managers are divided by size, style, and investment approach and evaluate their performance against a specific benchmark. For instance, growth managers are compared with a growth benchmark.

On one hand, traditional equity managers take position with a long-only constraint : they can own stocks but have an inability to go short and to use leverage. According to the analysis of Finn, Fuller, and Kling, shorting a stock can grab an opportunity to add value to a portfolio

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which can be two times more benefit than an opportunity on the long side¹ . Therefore, the return of a portfolio manager from the identification of an overvalued stock can be limited by this constraint. In other words, the long-only constraint put a stop to managers from fully implementing some of their views² . For instance, constrained managers can use a negative insight only by underweighting a stock relative to its benchmark weight. In fact, a Traditional portfolio manager can derive little benefit from negative views. Note that, the long-only constraint becomes more binding as target tracking error increases. This later is a measure of active risk which comes from the attempt to beat the benchmark by the manager. In other words, an increase of active risk is translated into more views that are not fully implemented because of long-only constraint³ .

On the other hand, an active management can be successful if the managers detect market inefficiencies and have the ability to implement those insights, as we see before it can be pretty difficult. With this portfolio construction, the managers have to do two things at once. Firstly, they have to invest in the equity market to obtain the beta. Secondly, they try to add value through stock selection. They cannot focus on a specific task, so managers fully invest in the benchmark market at all time and keep low tracking error relative to this benchmark. One more weakness, this strategy requires large management cost for manager fees and rebalancing. To put in another way, the traditional portfolio construction has alpha-type costs to only get beta or less. Another point approves the previous sentence, managers tend to track the benchmark to avoid the risk of being fired, by consequent they dilute their alpha⁴ .

With regarding to the two previous point, there is some obstacle to have a benefit portfolio by using this strategy. Moreover, the asset allocation methods to achieve a return while keeping

1. Finn. MarkT.,Russell J. Fuller. and John L. Kling. "Equity Mispricing : It's Mostly on the Short Side." Financial Analysts Journal. November/December 1999.

2. Ronald N. Kahn "What Plan Sponsors Need from Their Active Equity Managers." Association for Investment Management and Research, 2002.

3. Ronald N. Kahn "What Plan Sponsors Need from Their Active Equity Managers." Association for Investment Management and Research, 2002.

4. Clifford H. Quisenberry, "Core/Satellite Strategies for the High-Net-Worth Investor", CFA institute, 2006.

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a certain risk control, have non negligible limitations. The strategic asset allocation tends to give erroneous portfolio weight by not taking into account the movements in asset correlation through time. The tactical asset allocation relies on the correct and consistent prediction of the future price variation; the academic research showed that just few managers consistently have a right expectation. An academic research highlight this failure and the underperforming in general, 80% of active manage funds underperform the market. The part of fund which outperforms are often never the same which outperforms in the next period⁵ .

Furthermore, the tax code penalizes this traditional approach because its high turnovers increase the taxation of the market return. Therefore, it's very difficult for active managers to beat their benchmark, net of fees and after-tax basis, especially in strong bull markets.

That's why logically advisers were looking for a better way to manage an asset portfolio. The core/satellite was «born» from the issues in implementing a traditional portfolio. With this approach and its separation of alpha and beta, they found a way to avoid those constraints and allow a better concentration for each manager. By consequent, the core/satellite approach has rapidly become a major portfolio strategy of these advisers. The recent crisis helped this ascension.

2.2 The features of this approach

The core-satellite strategy allows to match the portfolio to the client's risk aversion, like traditional approaches. The whole portfolio is managed to be efficient in a taxable client's three-dimensional space : return, risk and taxes. The basement of this approach is to drive the portfolio in specific directions, or to control its performance as it is impacted by the three previous factors. This method is designed to minimize costs, tax liability and volatility while

5. William R. Thatcher,«When Indexing Works and When It does not in U.S. Equities : the Purity Hypothesis", 2009

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providing an opportunity to outperform the broad stock market as a whole. The core-satellite approach must produce long term wealth creation. This strategy is based on asset allocation which is the main driver of long-term performance; that explain 94% of the movement in portfolio returns⁶ .

2.2.1 What about the core?

The core of the portfolio consists mostly of passive investments that track the performance of major market indices like the S&P500 in the US or the CAC40 in Europe. By following such indices, it is a cap-weighted portfolio. Its goal is to generate beta; it should not generate performance alpha. Note that Beta is the performance delivered by the market and Alpha is the performance delivered by a manager over and above what the market delivers.

A Passive managers will purchase investments with the intention of long-term appreciation and limited maintenance. By consequent, low fees are expected for this kind of portfolio manager. So the core portfolio should be relatively inexpensive. The most appropriate core is a broadly diversified portfolio, built with ETFs, Index Funds, or tax-enhanced index. It should take a long-term view with rebalancing maybe once per year. A tax managed core allows to increase the after-tax return. Regarding to the low turnover and the low gain realization provided by a passive management, the core is as well tax efficient. Note that it can be improved if it is tax managed by using a tax-loss harvesting strategy. That is to say the ideal core strategy depends on the investor's overall tax situation. We're going to speak about that in another section.

2.2.2 What about the satellite?

The satellite positions are added into a portfolio by taking into account the goals of the investor and the investor's tolerance for risk and illiquidity, time horizon, and non-transparency. This part of the portfolio is in the form of actively managed investments, several portfolios

6. Roger G. Ibbotson, Paul D. Kaplan, "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?", 2000.

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of active manager. This kind of manager are aggressive alpha seekers with fewer investment constraint, they continuously monitor their activity in order to exploit profitable conditions across multiple markets (market inefficiencies). In other words, they allow to get access to active risk strategies that have an attractive expected return. So to choose a specific satellite strategies, an investor must be considered the return to active risk offered by each strategy. Managers implement different strategies according to the market capitalization and the style (e.g. mid-cap value) to mostly produce long term gains. The satellite components can be a «concentrated» long short equity portfolio, private equity or hedge fund (market neutral one). Unlike the core, the satellite is not tax efficient because of its possible high turnover and capital gains. Even of this tax inefficiency and high fees, an investor is willing to pay for active strategy to get alpha. Finally, managers must have to cover taxes and fees, so they must produce enough excess return.

The satellite part is independent of the core part, that is to say exhibits a low correlation with the benchmark. So the diversification level of the portfolio increases. This fact enhances the total performance consistency, especially in down markets.

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

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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.

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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

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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.

2.3 One last word!

In 2014, 50% of ETF investors have run a core/satellite strategy, which represents a 2% increase than 2013 ⁹ . According to the features of this approach, a higher use will not be surprising. But this later needs a large amount of invested money. For instance, according to Quisenberry (2006), the core portfolio can be effectively managed with a minimum of $250 000 of investment. So a lot of investors cannot implement this strategy under this constraint.

To implement this strategy, advisers have to take into account the investor's goal to align the asset allocation with his need. Overall, with this approach, investors expect to take an advantage in terms of return from the smart asset allocation and the active manager selection. The cost-and tax-effectiveness of Exchange-Traded Fund (ETF) can facilitate the implementation of this portfolio construction.

3 ETF, a young financial instrument

3.1 An ETF, what is it ?

ETFs are «new» vehicles, they appears in 1993 in the U.S. At the end of 2007, there were 1171 ETFs in the whole world, with underlying assets close to $800 billion ¹⁰ .

9. The EDHEC European ETF Survey 2014.

10. According to Morgan Stanley.

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An Exchange-Traded Fund (ETF) is marketable security that tracks an index, a commodity, or a basket of asset like an index fund. Its goal is to replicate the performance of its underlying index. Therefore, an ETF which is tracking a particular index, will hold the same securities, and in the same proportion of this one. An ETF pays out dividends received from the underlying stocks on a quarterly basis.

Unlike index funds, an ETF trades like a common stock on a stock exchange. Thanks to its presence in both primary and secondary market, ETFs typically have higher daily liquidity than traditional mutual funds. The supply and the demand in the secondary market determine the price of ETF shares; this later can diverge from the value of the underlying securities net asset value (NAV). This fact provides an arbitrage opportunity for investors, one of the main feature of ETF. Note that the arbitrage activity keep very close the ETF price and the underlying securities NAV.

Furthermore, ETFs have low fees, this is due to the fact that an ETF is passively managed. Note that few actively managed ETFs exist. This reduction in cost can be balanced by the fact that investors must pay a brokerage commission to purchase and sell ETF shares. For those investors who trade frequently, this can significantly increase the cost of investing in ETFs.

Its daily liquidity allows a consequent flexibility, that's why it can be an attractive alternative to implement various investment strategies like hedging strategies, or to build an investment portfolio. For portfolio construction, one of the main advantage of this instrument is the broad diversification that it can provide. Add to total and broad market ETFs, a lot of type of ETFs exists, like sector ETF, market capitalization ETF (large, mid, small cap), fixed income ETF, currency ETF, commodity ETF, bond ETF, etc. The combination of several of them allows the investor not only to diversify across all the major asset classes but also to diversify into investments that have a low correlation to the major asset classes (commodities, emerging

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market...). Furthermore, the diversity of ETFs allows to achieve specific segment of the market through low-cost indexes. Before, those segments could be reached through active management.

Another advantage of this instrument is its tax efficiency. It's come from the fact that most of ETFs have very low turnover, so investors amass only few capital gains by holding them. Moreover the tradability of ETF allows to sell it to another investor like a stock, this means no capital gains transaction for the ETFs. Moreover, ETFs offer better transparency into their holdings than mutual funds. ETFs disclose their full portfolios on public every single day of the year.

Overall, ETFs combine the advantages of both index funds and stocks. They are convenient, cost efficient, tax efficient and flexible; their diversity allows an investor to easily fill the «holes» in his portfolio to get a broad diversification. This vehicle provides investors the market exposure they require, at the level they want, at the time need it.

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

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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;

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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.

3.3 One last word!

In this European ETF survey (2014), the EDHEC risk institute provides some statistics about the preference of European investor for ETFs for their asset allocation in both core and satellite (Appendix 1). The most use ETF in the core is the broad market ETF. For instance, 69% of equity broad market ETFs users use them in the core. Whereas style, sector and other narrow ETFs lie mainly in the satellite. For instance, 59% of equity sector ETFs users use them in the satellite. Note that these ETFs are clearly less popular than broad-based ETFs. Some investors use ETFs both in core and satellite. The equity broad market ETF is the one which is the most use in both part of the portfolio (12,5%). This study approves what I said in the two previous section. That is to say, the narrower ETFs are widely used as satellite vehicles for tactical asset allocation and the core is built around broad market ETFs to get a broadly diversification.

To sum up, ETFs are especially adapted to the core/satellite approach. They offer a natural vehicles for implementing allocation strategies both in the core and in the satellite. Their use can help to optimize the risk/return of the portfolio. On one hand, they allow to get easily a broadly diversified core. On the other hand, they can help investors to improve the return of the portfolio thanks to the addition of specific ETFs in the satellite. Their tradability is one of their main advantages, we're going to see that this later allows the management of highly dynamic strategies by facilitating the shifts from the core to satellite.

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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.

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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.

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»

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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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5 Conclusion

The core/satellite strategy appeared in the financial world after that the portfolio construction, provided by the modern portfolio theory showed some issue and tended to underperform against a particular benchmark. Most financial agents argue that investors can extract several benefits from this portfolio construction.

My goal was to find the best way to take an advantage from the core/satellite by using ETFs. Effectively, I think that this financial vehicle has to take part in a core/satellite because of this features which can overcome the few issues of this portfolio strategy like the lack of transparency and liquidity in the satellite.

Secondly, when an investor has this kind of portfolio, he has to accurately define his financial objectives to choose the right allocation between the core and the satellite, and by consequent he could optimize the return/risk pair.

Thirdly, an investor has to be aware of his tax situation. In fact, an investor expect to get the higher after-tax return. A tax management in his portfolio can increase the performance of this one.

This strategy has a major limit. It is not reachable to everyone to implement this approach. The core/satellite construction can be used only by high-net-worth investor. But even that, nowadays this strategy is considered as one of the main driver of portfolio construction. This dissertation allows me to discover the ETF and the core/satellite strategy.

In this first work, I have been pretty general in my analysis to get a first approach of this environment. In a future work, I would like to focus on the dynamic way to manage a core/satellite portfolio and particularly the model about the DCS approach provided by the EDHEC risk institute

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6 Appendix

-- 1. Summary of the use of different instruments in the core/satellite allocation

7 References

7.1 Academic references

-- Scott Welch, "The Hitchhiker's Guide to Core/Satellite Investing", The journal of wealth management, Winter 2008.

-- Donald J. Mulvihill, "Core and Satellite Portfolio Structure : Investments and Tax Considerations",The journal of wealth management, Summer 2005.

-- Clifford H. Quisenberry, "Core/Satellite Strategies for the High-Net-Worth Investor", CFA institute, December 2006.

-- Donald J. Mulvihill, "Core and Satellite : Implementation Issues", The journal of wealth management, Spring 2006.

-- N. Amenc, F. Ducoulombier, F. Goltz, V. Le Sourd, A. Lodh, and E. Shirbini, "The EDHEC European ETF Survey 2014", EDHEC-Risk institute, March 2015.

-- 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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-- Clifford H. Quisenberry, "Optimal allocation of a Taxable Core and Satellite Portfolio Structure", The journal of wealth management, Summer 2003.

-- N. Amenc, F. Goltz, and A. Grigoriu, "Risk Control Through Dynamic Core-Satellite Portfolios of ETFs : Applications to Absolute Return Funds and Tactical Asset Allocation", The Journal of Alternative Investments, Fall 2010.

7.2 Online references

-- "ETFs - Implementing Core & Satellite for SMSF & HNW Investors", www.LPAConline.com.au

M. Nairne, "How millionaires use ETFs to build 'core and satellite' portfolios", Financial Post January 2013.

-- S. Cohen, "Using ETFs to cut the cost of core-satellite", Professional Adviser, August 2013.

-- "Why Are ETFs So Tax Efficient?", textitwww.etf.com, January 2014.

-- "ETFs in Core-Satellite Portfolio Management", EDHEC Risk and Asset Management Research Centre.

N. Amenc, "The Core-Satellite Approach: Adding Value to Asset Management", EDHEC Risk and Asset Management Research Centre, November 2006.

-- J. Fink, "Using a Core and Satellite ETF Strategy to Generate Alpha", Investing Daily, January 2011.

-- "ETFs and core satellite investing", Professional Wealth Management, Summer 2008. -- www.investopedia.com