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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

satellite. But if economic conditions become temporarily unfavourable the satellite may in fact underperform the core. The dynamic core-satellite approach makes it possible to reduce a satellite’s impact on performance during a period of relative underperformance, while maximising the benefits of the periods of outperformance.

As it happens, investor expectations are rarely symmetric. In other words, when stock market indices perform well, investors are happy to be engaged in relative return strategies. On the other hand, when stock market indices perform poorly, they express a strong desire for absolute return strategies. Value-at-Risk minimisation and volatility minimisation allow only symmetric risk management. For example, the minimum- variance process leads to lost upside potential in the performance of commercial indices in exchange for lower exposure to downside risk. Although this strategy allows long-term outperformance, it can lead to significant short-term underperformance. It is also very hard to recover from severe market drawdowns. The dynamic core-satellite technique, by contrast, focuses on asymmetric risk management.

underperformance of the benchmark at the terminal date. This so-called floor is usually a fraction of the benchmark portfolio, say 90%. Investment in the satellite then provides access to potential outperformance of the benchmark.

Dynamic core-satellite investment has two objectives: to increase the fraction allocated to the satellite when the satellite has outperformed the benchmark and to reduce this fraction when the satellite has underperformed the benchmark.

This dual objective can be met with a suitable extension of CPPI to relative risk management. Let Pt be the value of the portfolio at date t. The portfolio Pt can be b r o k e n d o w n i n t o a f l o o r F t a n d a c u s h i o n C t , a c c o r d i n g t o t h e r e l a t i o n P t = F t + C t . B t i s t h e b e n c h m a r k . T h e f l o o r i s g i v e n b y F t = k B t , w h e r e k i s a c o n s t a n t l e s s Finally, let the investment in the satellite t h a n 1 . b e E t = w S t = m C t = m ( P t - F t constant multiplier greater than 1 and w the fraction invested in the satellite. The remainder of the portfolio, Pt - Et = (1-w) Bt, is invested in the benchmark. ) , w i t h m a

From an absolute return perspective, it is possible to propose a tradeoff between the performance of the core and satellite. This trade off is not symmetric, as it involves maximising the investment in the satellite when it is outperforming the core and, conversely, minimising it when it is underperforming. The aim of this dynamic allocation is to produce greater risk-adjusted returns than those produced by static core-satellite management. Like standard CPPI, this dynamic allocation first requires the imposition of a lower limit on

In a relative return investment, the core will contain some assets that closely track a given benchmark, whereas the satellite will have assets that ought to outperform this benchmark.

This method leads to an increase in the fraction allocated to the satellite when the satellite outperforms the benchmark. An accumulation of past outperformance results in an increase in the cushion and therefore in the potential for a more aggressive strategy in the future. If the satellite has underperformed the benchmark,

An EDHEC-Risk Institute Publication


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