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.
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