X hits on this document

106 views

0 shares

0 downloads

0 comments

8 / 44

8

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

Introduction

This paper examines the ways dynamic asset allocation techniques can be used to manage portfolios of exchange-traded funds (ETFs). First, dynamic allocation to stock and bond ETFs and traditional static diversification are compared. Second, tactical allocation to stock and bond ETFs and risk-controlled allocation—with both forms of allocation informed by the same return forecasts—are compared. The paper shows that dynamic asset allocation techniques that can be used with frequently traded and broadly diversified instruments such as ETFs make it possible better to address investor concerns over drawdown and intra-horizon risk, whether or not the manager wishes to make return predictions.

The asset management industry has traditionally focused largely on security selection. Following the evidence of the importance of asset allocation (Brinson et al. 1986), the industry has paid increasing attention to passive investment vehicles that provide exposure to broadly diversified baskets of securities. Such vehicles make security selection unnecessary and allow asset managers to concentrate on allocation to different asset classes or styles.

Asset managers have two main means of using asset allocation to add value. The first is strategic asset allocation, in which the goal is to diversify the asset mix so as to obtain the best possible risk/return tradeoff for investors. Strategic allocation depends mainly on the correlation of the returns of different asset classes and on the risk premia of these asset classes. The challenge is to estimate these parameters. In addition, correlations and risk premia are not necessarily stable. In particular,

diversification often fails when it is most needed, as correlation increases during crises (Longin and Solnik 2001). The second means is tactical allocation, which relies on predicting the short-term returns on different asset classes. Managers can then increase exposure to high-return asset classes and decrease exposure to low-return asset classes. The primary aim of tactical allocation is often outperformance rather than risk management.

Asset managers are relying more and more on ETFs to implement these strategies. The volume of assets invested in these funds has increased more than five-fold in the past six years, both in Europe and in the United States (Deutsche Bank 2009). Miffre (2007) and Hlawitschka and Tucker (2008) empirically assess the potential diversification afforded by holding more than one ETF. Amenc et al. (2003) and de Freitas and Barker (2006) analyse tactical allocations to ETFs on different asset classes and styles.

The objective of this paper is to analyse portfolios of ETFs that go beyond these traditional diversification and tactical allocation concepts. Rather than focusing on diversification alone, we apply dynamic risk management techniques that take into account investors’ aversion to intra- horizon risk. After all, investors are averse not just to end-of-horizon risk but also to negative outcomes within the investment time period (Kritzman and Rich 2002; Bakshi and Panayotovb 2009). Addressing these concerns requires dynamic risk management. We first analyse how this concept can be used when, in the absence of any views on the returns to these asset classes, decisions to allocate to stocks and

An EDHEC-Risk Institute Publication

Document info
Document views106
Page views106
Page last viewedSun Dec 04 19:48:14 UTC 2016
Pages44
Paragraphs724
Words10199

Comments