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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

core and the satellite. The graph also shows the dynamics of the floor, which reflects the degree of protection. It is likewise instructive to look at the performance in the stock market downturn beginning in the year 2000. In fact, the DCS portfolio is largely unaffected. As the portfolio value approaches the floor, the allocation shifts to the core. This behaviour is also illustrated in exhibit 2, which shows the weights held in the satellite portfolio over time.

Risk and return statistics for the DCS strategy confirm the conclusions from exhibit 1. In particular, exhibit 3 shows that the average return exceeds that of the core by almost 200 basis points, all while keeping risk as low as that of the defensive core.

It should be kept in mind that the conservative nature of the core and the dynamic risk management process are

meant to result in smooth returns, in the sense that investors should experience little risk within the entire investment period. Exhibit 3, however, shows statistics that reflect risk at the end of the investment period. Investors obviously care about intra- horizon risk, that is, about losses that occur within the full investment period from December 1998 to December 2008.

Exhibit 4 shows the returns over rolling periods of one year. We see that the DCS portfolio posts positive returns over most rolling windows of one year. Even for the most recent observations of trailing returns, the strategy generates positive numbers, unlike the satellite, which, for the same periods, posts returns worse than -40%. In fact, the behaviour of the DCS portfolio is similar to that of the defensive core of bonds.

December 1998 –December 2008

Average return*

Maximum drawdown

Volatility*

Sharpe ratio*/**

Core

4.44%

-3.08%

2.61%

0.94

Satellite

-0.99%

-59.90%

19.46%

-0.15

Static core-satellite

2.26%

-27.92%

9.22%

0.03

DCS

6.41%

-3.11%

3.83%

1.15

Exhibit 3: Absolute return fund: risk and return statistics for the core, the satellite and both static and dynamic core-satellite investments

  • *

    annualised statistics; ** risk-free rate fixed at 2%

Exhibit 4: Absolute return fund: performance of the core, the satellite and the DCS over a one-year rolling period

An EDHEC-Risk Institute Publication

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