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


In short, the applications of dynamic risk budgeting described in this paper highlight the potential benefits of using ETFs to gain exposure to several asset classes and the advantages of the dynamic risk management approach. The main benefit is the combination of participation in upside market movements and limited risk exposure. As a result, dynamic core-satellite strategies often offer better risk/return tradeoffs than either core or satellite investments. In addition, maximum drawdown—extreme risk—is limited. The applications show that, when attempts to add value in constructing portfolios of ETFs are made, risk control may be no less important than diversification and return predictions.

The analysis in this paper can be extended in different ways. First, the paper has addressed the shifting weights on allocation to ETFs on stocks and on allocation to bonds. ETF providers have recently issued an increasing number of ETFs on alternative asset classes, such as currencies, commodities, and real estate. It may be worth analysing the integration of such vehicles into a risk-budgeting framework. Second, a simulation study with hypothetical return predictions was used to analyse the strategy with a dynamic multiplier introduced in this paper. A natural extension of this analysis would be to introduce return predictions based on well known stylised facts, such as the relationship between dividend yield and stock returns. These issues are left for future research.

An EDHEC-Risk Institute Publication

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