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

3. Beyond Tactical Bets: Integrating Predictions in a Risk-Controlled Framework

Hit ratio

7/12

8/12

9/12

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11/12

Risk reduction (reduction in

40%

30%

20%

12%

4%

Exhibit 7: Risk reduction: risk-controlled forecast-based strategy versus standard tactical allocation. This exhibit shows the reduction of the average drawdown obtained by using the DCS approach to implement portfolios based on predictions of outperformance of the satellite portfolio over a one-month horizon.

magnitude of avg. max. drawdown)

The two strategies assume identical forecasting ability. The results demonstrate that the DCS approach reduces the risk of tactical bets based on return forecasts.

This application underscores the benefits of DCS investment even for managers who prefer to rely, as it were, on their crystal balls. DCS management may also improve the downside risk management of portfolios when an asset manager wishes to use forecasts to make tactical bets.

An EDHEC-Risk Institute Publication

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