8/8/2019 Core and Satellite

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Knowledge Series Discussion Paper

Core and Satellite portfolio

The behavioral biases of investors and the active fees charged by the asset

management firms are important factors that drive the portfolio construction process.In this paper, we discuss a portfolio framework that addresses these two factors.

Returns on a portfolio are derived from two sources- alpha returns and betaexposure. A portfolio generates beta returns because of its exposure to the market.In the portfolio theory, this comes off the Capital Asset Pricing Model (CAPM), whichstates that investors can only expect to earn market return if they assume marketrisk.

The portfolio’s alpha returns refers to the excess return over the benchmark indexthat a portfolio manager generates because of her skill. The manager’s skill comesfrom security selection and, sometimes, from market timing.

All active managers charge higher fees than index funds do, with a promise to deliveralpha returns. Suppose an active fund charges fees of 2.5 per cent. Further suppose90 per cent variation in fund returns can be explained by the change in thebenchmark index (captured the measure R2). The investor is then essentially payingalpha fees to the fund that largely (90 per cent) generates beta returns.

What if the investor can buy index fund for the 90 per cent beta exposure and anactive fund for the 10 per cent alpha exposure? That way, she can save on payingactive fees on the entire portfolio. This is rationale behind the alpha-beta separation.

The core-satellite framework is built on this alpha-beta separation. The core portfoliois exposed primarily to the benchmark risk and therefore earns the benchmark return(beta exposure). The alpha portfolio is set-up to outperform the benchmark.

Investors can construct the core portfolio through low-cost beta exposure, typically inindex funds and benchmark fixed-income securities. This is believed to be an optimalstrategy for all classes of individual investors- mass affluent, HNWIs and Ultra-HNWIs. Typically, index funds benchmarked to a broad index such as the S&P CNX500 is preferable.

The satellite portfolio contains exposure to styles such active mid-cap funds, sectorfunds and direct exposure to stocks. Investors should also consider exposure toalternative asset class such as commodity through commodity futures. HNWIs andUltra-HNWIs should consider alternative strategies on existing asset classes such asprivate equity and hedge funds, as they are also good alpha generators.

The core-satellite portfolio framework is behaviorally optimal. A typical investor wouldlike to invest for the long-term but want to profit from short-term asset pricemovements. The core portfolio takes care of the long-term investment objective whilethe satellite portfolio satisfies the urge to have continual cash flow into the tradingaccount.

We defer the treatment on the allocation of assets between the core and the satelliteportfolio to another discussion paper on the subject.