A core-satellite management consist in having a core portfolio made up of passive management vehicles (index funds, ETFs, etc.) with low management fees, and separately one, or several, very active satellites that are made up of funds with a strong tracking error, or even funds with no constraint whatsoever on managing relative risk with regard to a benchmark (hedge funds, for example). The purpose of the core component is to control management risks and to improve the efficiency of the overall portfolio by limiting costs. The role of the active components is to provide diversification and to generate out-performance. The core-satellite portfolio model was adopted by institutional investor's years ago. However, the wish to improve the investment efficiency after the adverse market conditions of the early 2000, have helped the move to this strategy during the past years.
[...] The satellites, on the other hand, are generally selected for their potential to add value, both through enhancing returns or by reducing portfolio risk. They are allocated to less efficient market requiring specialist skills. Satellite investments may include mutual funds, hedge funds, private equity, real estate, stocks of emerging companies or sector funds, to name a few. Great candidate for satellite investments include less efficient asset classes where the potential for active management to add value is increased, particularly where those assets offer returns that are not closely correlated with the core or with other satellite investments. [...]
[...] Many practitioners of market-neutral long/short equity trading balance their longs and shorts in the same sector or industry. By being sector neutral, they avoid the risk of market swings affecting some industries or sectors differently than others. The second is the optimal substitution: some strategies can be used as return enhancer. Therefore equity-oriented investors can use them to replace equity in their core portfolio. We give here two examples of return enhancers, the definitions are taken from the Appendix “Information on Hedge Fund Strategies” of the working paper “Portfolio Optimization and Hedge Funds Style Allocation Decision” written by Noël Amenc and Lionel Martellini (2002) Event Driven: Corporate transactions and special situations Deal Arbitrage (long/short equity securities of companies involved in corporate transactions) Bankruptcy/Distressed (long undervalued securities of companies usually in financial distress) Multi-strategy (deals in both deal arbitrage and bankruptcy) Long/Short Equity: Invests both in long and short equity portfolios generally in the same sectors of the market. [...]
[...] They can also be used in the satellites to remove the systematic exposure from a long strategy and create a portable alpha component. By identifying the best hedge, the beta exposure is neutralized by taking a short position in an ETF. Core-satellite strategies can be a solution, which generate alpha while preserving benefits of ETFs. While the core delivers the index performance at a moderate expense ratio, the satellites are investments that search for alpha. Diversification and de-correlation can be calibrated as needed to obtain the client's desired risk level. [...]
[...] When the market price differentiates from the NAV of a fund, arbitrageurs profit from the disparity. The arbitrage force therefore keeps ETF prices very close to the NAV. Compared to the low liquidity of futures, high liquidity of ETFs is observed on the bid/ask spreads. The average bid/ask spread for the ETF tracking the telecom sector is about 10 bps while the corresponding spread is more than 30 bps for future contracts on DJ STOXX Telecom by 2006. What are the ways to use ETFs? [...]
[...] This is why the alternative risk factors of hedge funds can be really interesting. The portfolio including hedge funds should resist better in case of extreme market conditions. To be optimal, this diversification as to follow certain rules: the strategies should allow them to gain exposure to risk factors that are different from those driving the performance of traditional asset classes. Optimisation process Step one It is very difficult to model the ex-ante returns of a hedge fund strategy due to the characteristic of alternative investments (mentioned above). [...]
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