| Core-Satellite 101 |
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| 24/10/2004 | |
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This week's 101, answered by Nigel Loweth of Axa Investment Managers, is dedicated to the core-satellite approach. 1-What is the core-satellite approach? A core-satellite approach is an investment strategy that combines passive and active investment management styles. The idea is that the appropriate combination can achieve a synthetic enhanced indexing, which aims to consistently outperform a chosen benchmark. The principle behind the core-satellite approach is that most of the portfolio will be dedicated to matching its benchmark with low risk, while a smaller allocation will target enhanced returns so that, when the two elements are combined, the portfolio is potentially able to beat its benchmark in a risk-controlled manner. Under this approach, the bulk of the portfolio (the 'core') is invested in passively managed funds, while the rest is invested in actively managed, high-alpha funds, which make up the satellite element. The passively managed funds should be able to produce returns that are close to benchmark with very low tracking errors and at low cost. The satellites, in contrast, will aim for higher returns, for instance 3% over benchmark. 2-What kind of institutional investors is it designed for? In principle, the core-satellite approach offers an excellent strategy for a wide range of investor profiles. The approach is quite flexible in that the portfolio manager can select the most suitable weightings for the core and satellite elements. The flexibility also extends to the amount of alpha in which the investor is targeting (and level of risk that is tolerable). This approach could be a natural progression for a portfolio that has a pure passive strategy, but where the investor wants to exceed the performance of the benchmark, rather than just matching it. 3-What are the alternatives to the core-satellite approach? How does the core-satellite approach differ from those alternatives? Another possible approach is the 'packaged', or 'portable-alpha' approach, where high alpha assets are used again to supplement traditional assets. In this case, however, the alpha derived from one type of asset is 'transferred' to another asset. The packaged method has been very successful and popular with cash funds, as a means of enhancing the potential returns of this very-low-returning asset class. A convertible-arbitrage strategy hedge fund (typically going long a convertible bond and short the stock of the same company) can be added to a traditional cash portfolio to provide the outperformance in a risk-controlled manner. The portable alpha can be packaged and used to fulfil specific needs, with the cash-plus situation describe above being a prime example. Alpha can be introduced into more traditional approaches or benchmarks to complement and improve the overall risk-adjusted return profile – the objective is to add de-correlated alpha each time. The alpha generates the outperformance of the fund or mandate, irrespective of the related asset classes and benchmark. However, this packaged approach requires expertise both in terms of structuring and in terms of absolute returns. |
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