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Risk Control through Dynamic Core-Satellite Portfolios of ETFs: Applications to Absolute Return Funds and Tactical Asset Allocation — January 2010

1. Method: Dynamic Risk Budgeting

In the remainder of this paper, we draw on the core-satellite approach to make allocations to ETFs. This section first introduces the basic dynamic core-satellite approach and then discusses possible extensions.

1.1. Dynamic Core-Satellite Portfolio Choice The core-satellite approach divides the portfolio into a core component, which fully replicates the investor’s designated benchmark, and a performance-seeking component, made up of one or more satellites, which is allowed higher tracking error. Although the weights allocated to the core and to the satellite can be static, the proportion invested in the performance- seeking portfolio (the satellite) can also fluctuate as a function of the current cumulative outperformance of the overall portfolio, thus making the approach dynamic.

The dynamic core-satellite concept builds on constant proportion portfolio insurance (CPPI). This principle, described by Black and Jones (1987) and Black and Perold (1992), allows the production of option-like positions through systematic trading rules. CPPI dynamically allocates total assets to a risky asset in proportion to a multiple of a cushion defined as the difference between current portfolio value and a desired protective floor. The effect is similar to that of owning a put option. In CPPI, the portfolio’s exposure tends to zero as the cushion approaches zero; when the cushion is zero, the portfolio is completely invested in cash. So, in theory, the guarantee is perfect: the strategy ensures that the portfolio never falls below the floor; in the event that it touches the floor, the fund is

“dead”, i.e., it can deliver no performance beyond the guarantee.

This CPPI procedure can be transferred to a relative return context. Amenc, Malaise, and Martellini (2004) show that an approach similar to standard CPPI can be taken to offer the investor a relative performance guarantee (underperformance of the benchmark is capped). Conventional CPPI techniques still apply, as long as the risky asset is re-interpreted as the satellite portfolio, which contains risk relative to the benchmark, and the risk-free asset is re-interpreted as the core portfolio, which contains no risk relative to the benchmark. The key difference from CPPI is that the core or benchmark portfolio can itself be risky. In a relative-risk context, the dynamic core-satellite investment can be used to improve the performance of a broad equity portfolio by adding riskier asset classes to the satellite. Dynamic core-satellite investing may also be of interest to pension funds, which must manage their liabilities: the core then is made up of a liability-hedging portfolio, and the satellite is expected to deliver outperformance.

This dynamic version of a core-satellite approach, which can be seen as a structured form of portfolio management, is hence a natural extension of CPPI techniques. The advantage is that it allows an investor to truncate the relative return distribution so as to allocate the probability weights away from severe relative underperformance and towards greater potential outperformance.

Core-satellite portfolios are usually constructed by putting assets that are supposed to outperform the core in the

An EDHEC-Risk Institute Publication

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