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

2. Beyond Diversification: Absolute Return Funds of ETFs

Combining equity ETFs and bond ETFs may, as a result of diversification, lead to risk reduction, but weighting stocks and bonds statically does not fully exploit the possibilities of risk management. So this section assesses the ways in which dynamic adjustments of exposure to a bond core (short maturity EuroMTS ETF) and an equity satellite (equity ETF) can ensure that an absolute return fund reaches its objectives.

Although there is no single definition of the absolute return concept, most investors interested in such strategies have two main expectations, one having to do with performance management and the other with risk management. In other words, they have a performance target (usually expressed as a multiple of a cash rate or as a constant target) that they expect to hit regardless of market conditions, and they expect to avoid large drawdowns (with a maximum drawdown set at 10% in the application that follows). In an absolute return product, the investor also expects the probability of losing money over any one-year period to be extremely low. Our assumption is that, however equity markets perform, an absolute return product will avoid posting negative returns over a one-year horizon. This constraint can be accommodated with a twelve-month trailing performance floor.

cap stock ETF (both in the euro zone); the maximum allocation is set at 50%.

Specifically, we combine a core that invests in medium-term bonds (EuroMTS for bonds with three to five years to maturity) and a satellite that invests in an ETF on the EuroStoxx 50 index. The objective is to optimise returns while limiting the drawdown risk of the portfolio to 10%. The intuition behind the maximum-drawdown constraint is that the investment in the risky asset depends not only on risk aversion but also on the margin for error. When the risk budget is spent, one should be prepared to move away from the risky asset. The idea is to benefit from the returns on the stock market ETF if stocks outperform bonds, while securing protection from the downside risk of the equity investment.

The data used consists of monthly returns, including reinvestment of coupon or dividend payments, for the period from January 1999 to December 2008. The starting period is chosen in this way because the bond data is available starting only with the introduction of the euro, as is usual for euro-denominated bond indices. The strategy for this form of absolute return fund is, of course, one of many possible means of meeting the objectives of absolute return investors. The dynamic core-satellite strategy, in short, is flexible enough to design a broad variety of investment strategies.

We first specify a maximum drawdown equal to 10%, a twelve-month trailing performance floor, and a soft landing objective with respect to a performance cap (investment goal) set at 2.5 times the cash rate. We then proceed with dynamic core-satellite allocation, the core invested in a bond ETF and the satellite in a large-

Exhibit 1 shows the cumulative returns of the strategy we implemented, as well as of the core and the satellite portfolios. In addition, to highlight the built-in protection of this investment strategy, the floor is displayed as well.

An EDHEC-Risk Institute Publication

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