Risk Control through Dynamic Core-Satellite Portfolios of ETFs: Applications to Absolute Return Funds and Tactical Asset Allocation — January 2010
to bonds are made. We describe a dynamic risk management technique that makes it possible to provide relatively smooth returns with limited risk, an outcome similar to that sought by the absolute return funds that have proliferated in recent years. We then introduce a novel means of using forecasts of asset class returns to construct dynamic portfolios of stock and bond ETFs. Rather than using a strategy in which asset class weights depend only on return predictions, we take the dynamic core-satellite approach to act on return predictions—the dynamic risk budget is a given. The aim of the approach is to provide an element of risk control. Expected outperformance of an asset class does not lead directly to changes in weights. Instead, we adjust the multiplier in the dynamic strategy in keeping with the predicted outperformance, thus changing the weights indirectly. We show that, even if the manager is an excellent forecaster, this approach yields risk-control benefits considerably greater than those of standard tactical asset allocation.
The paper proceeds as follows. Section one describes the method we apply to the management of portfolios of ETFs. Section two discusses the application to the management of absolute returns and section three considers tactical bets. A final section provides conclusions.
An EDHEC-Risk Institute Publication