core/satellite portfolio construction
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Own Your Share.Own Your Share.
Core/Satellite PortfolioConstruction
Budgeting for Active Manager Risk
2
Agenda
What is Core/Satellite?
Asset allocation policy & active manager risk budgeting
Implementation
Example
3
10 largest US defined benefit pension plans
Source: Nelson’s Directory of Plan Sponsors, January 2001.
Plan sponsorDB assets
$BReport both index and
active portfolios
California Public Employees Retirement 171.9 X
New York State Common Retirement 122.5 X
California State Teachers Retirement 110.0 X
Florida State Board of Administration 107.8 X
New York City Retirement System 101.7 X
New York State Teachers Retirement System 89.3 X
Teachers Retirement System of Texas 85.0
New Jersey Division of Investment 83.1
General Motors 81.8
State of Wisconsin Investment Board 65.6 X
4
Top managers ranked by worldwide institutional assets
Source: Pensions & Investments, May 2001
Rank Firm Assets $B
1 Barclays Global Investors 756,300
2 State Street Global 712,203
3 Fidelity Investments 646,986
4 Deutsche Asset 436,990
5 JP Morgan Fleming 396,056
6 Merrill Lynch 289,500
7 TIAA-CREF 281,249
8 Vanguard Group 259,499
9 Alliance Capital 236,518
10 Prudential Insurance 235,106
Source: Pensions and Investments, May 2001.
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Institutional strategy evolves toCore/Satellite
Modern portfolio theory
Active-only produced benchmark risk
Solution: Index/active blend
Index core portfolio (multi-asset class)
Active managers layered to enhance returns
“Core/Satellite”
Index ETF (Core)
Activemanagers(Satellites)
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Potential return %
Risk %
0
Overall strategy starts with asset allocation policy
Treasury Bills
Long Term Treasury Bonds
Large Cap US Stocks
Small CapUS Stocks
InternationalStocks
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0
Overall strategy starts with asset allocation policy
Treasury Bills
Lehman Bros.Gov’t/Credit
Russell 1000Russell 2000
MSCI EAFE
“Optimization” combines historical returns with expected future estimates, using asset
class benchmarks to create an “efficient portfolio”
(hypothetical illustration)
0Risk %
Potential return %
“Optimized Portfolio”
8
Active portfolio management presents “Active manager risk”
Active manager return
The over- or under- return earned by an active manager relative to a benchmark (“selection alpha” is “active return” or “excess return” relative to a specific style benchmark)
Active manager risk
The annualized standard deviation of a manager’s active return
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Risk %
Potential active risk %
-3
+3
-2
-1
+1
+2
0
Core/Satellite implementation presents risk-return tradeoff
When implementing their asset allocation strategy with active managers, investors seek active return and experience active risk, relative to each asset class benchmark
Potential activereturn %
Russell 1000
Potential return %
2 4 6
There can be no assurance that an investment strategy based on the core/satellite hypothetical analysis will be successful.
10
-8.00
-6.00
-4.00
-2.00
0.00
2.00
4.00
6.00
8.00
10.00
10
Positive alpha
Negative alpha
Russell 1000 Growth
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Active manager tracking error
Active Manager Risk Hypothetical
Alp
ha
%
5.1% Avg. Annual Tracking Error1.26% Avg. Annual Alpha
Large-cap growth manager historical selection alpha vs. Russell 1000 Growth
For illustration only. Not indicative of any investment or manager.
11
11
-8.00
-6.00
-4.00
-2.00
0.00
2.00
4.00
6.00
8.00
10.00
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
All active portfolio
Portfolio with a 2% risk budget implementing active and index managers
Alp
ha
%
Lower Active Manager Risk HypotheticalUsing Risk Budgeting
2% Risk Budget = 2% Avg. Annual Tracking Error
Large-cap growth manager historical selection alpha vs. Russell 1000 Growth
For illustration only. Not indicative of any investment or manager.
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2/3 of time selection alpha falls within this range
(4 out of 6 years)
+5.1%
-5.1%
Illustration of 5.1% Hypothetical Tracking Error
A Model of Active Manager Returns
Tracking Error
— Standard Deviation of a Manager’s Selection Alpha
1/6 of time negative selection alpha is –5.1% or more (1 out of 6 years)
1/6 of time positive selection alpha is +5.1% or more (1 out of 6 Years)
Benchmark Return
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2/3 of time selection alpha falls within this range
(4 out of 6 years)
+5.1%
-5.1%
Illustration of 5.1% Hypothetical Tracking Error
A Model of Active Manager Returns
Tracking Error
— Standard Deviation of a Manager’s Selection Alpha
1/6 of time negative negative alpha is –5.1%
or more (1 out of 6 years)
1/6 of time positive selection alpha is +5.1% or more (1 out of 6 years)
+2.0%
-2.0%
2% Risk Budget
Benchmark Return
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Real world comparison
Actively managed funds that underperformed their index before tax (and after tax)
Source: Morningstar. US equity mutual funds. Russell Indexes. All total returns reflect 10 year annualized figures. Funds are categorized by their Morningstar objective; Specialty funds were categorized by their December 31, 2001 Morningstar style box.
12/31/91–12/31/01 Value Blend Growth
Before tax %
After tax %
Before tax %
After tax %
Before tax %
After tax %
Large-cap 84 93 76 94 56 82
Mid-cap 56 85 63 89 58 88
Small-cap 74 97 21 57 9 30
Past performance is no guarantee of future results
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Benchmark =Mgr. Avg.
+5.5%
-5.5%
Before fees and costs
Benchmark
-6.5%
+4.5%
“Good”Managers
“Bad”Managers
After fees and costs
Mgr. Avg. = -1%
A model of active manager returns
“Properly measured, the average actively managed dollar must under-perform the average passively managed dollar, net of costs”
— Bill Sharpe, The Arithmetic of Active Management
Source: Sharpe, “Arithmetic of Active Management”, Financial Analyst Journal, Jan-Feb, 1991. Waring, Whitney, Pirone and Castille, “Optimizing Manager Structure and Budgeting Manager Risk,” Journal of Portfolio Management 25, Spring 2000.
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Benefits of active manager risk budgeting
Implement client’s asset allocation with more benchmark “purity” than an all-actively managed portfolio
Allow active managers to still add active return (alpha)
17
Active manager risk budgeting
The lower an investor’s tolerance for active risk, the lesser proportion of the portfolio that will be devoted to active managers, greater proportion to index managers
Portfolios and risk budgets are customizable
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82 4 6 Tracking error %
Alpha %
Benchmark
(Russell 1000)
Moderate risk
Index fund 65%
Active mgr 35%
Implementing large-cap US equity managers An example
The real question:
How much active risk is too much?
Source: BGI analysis. Alpha and Tracking Error are not the only criteria to consider when developing an investment strategy. One cannot invest directly in an index. Indexes do not incur management fees, expenses or transactions costs
5.5
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82 4 6 Tracking error %
How much active manager risk?
Alpha %
Moderate risk
Index fund 65%
Active mgr 35%
Implementing large-cap US equity managers An example
Risk control “dial” controls the mix of selected managers
Source: BGI analysis.
Higher risk
Index fund 20%
Active mgr 80%
Benchmark
(Russell 1000)
5.5
20
Potential returns %
Risk %
0
Core/satellite active risk budgeting can be applied independently across asset classes
Russell 1000
MSCI EAFE
Lower active risk
Index fund 65%
Active mgr 35%
Higher active risk
Index fund 20%
Active mgr 80%
6% Active Risk Budget
2% Active Risk Budget
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Conclusions
“Active or Index” is the wrong way to look at the question
Instead see a “risk-control dial”, set an active manager risk level
Larger or smaller core investment depending on tolerance for risk
Ongoing monitoring and re-balancing adds annual value
Active manager risk budgeting involvesconsulting process, not product sales
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在經濟週期中﹐尋找投資契機
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醫療保健 高科技 醫療保健 高科技 高科技 醫療保健 黃金
高科技 能源 主要消費 電訊 礦業 公用事業 礦業
主要消費 醫療保健 高科技 醫療保健 電訊 主要消費 能源
電訊 主要消費 電訊 選擇性消費 選擇性消費 金融 選擇性消費
能源 選擇性消費 能源 公用事業 能源 能源 主要消費
金融 金融 金融 主要消費 金融 礦業 金融
公用事業 電訊 公用事業 金融 黃金 選擇性消費 醫療保健
選擇性消費 公用事業 選擇性消費 能源 醫療保健 黃金 公用事業
礦業 礦業 礦業 黃金 公共事業 電訊 電訊
黃金 黃金 黃金 礦業 主要消費 高科技 高科技
1995 1996 1997 1998 1999 2000 2001*
行業輪動
最差
.....
..… 行
業績
效表
現 ..
.....…
最佳
全球產業輪動
24
全球債市輪動
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001High High High Bank High High High Investment High US InvestmentYield Yield Yield Loans Yield Yield Yield Grade Yield Govt Grade
Bonds* Bonds Bonds Bonds Bonds Bonds Corporates Bonds Securities Corporates40.22% 18.36% 19.84% 10.32% 17.38% 12.98% 13.17% 7.87% 4.78% 11.89% 8.22%
Investment Muni Muni Money Investment Bank Muni US Money Muni USGrade Bonds Bonds Markets Grade Loans Bonds Govt Markets Bonds Govt
Corporates Corporates Securities Securities16.18% 8.90% 12.43% 3.74% 17.12% 7.48% 9.39% 7.84% 4.74% 11.10% 6.67%
US Investment Bank Investment Muni Money US Muni Bank Investment MuniGovt Grade Loans Grade Bonds Markets Govt Bonds Loans Grade Bonds
Securities Corporates Corporates Securities Corporates14.63% 7.22% 11.17% -3.21% 17.31% 5.01% 9.12% 5.64% 4.69% 10.58% 4.15%
Muni Bank Investment High US Muni Investment Bank Investment Money MoneyBonds Loans Grade Yield Govt Bonds Grade Loans Grade Markets Markets
Corporates Bonds Securities Corporates Corporates12.04% 6.75% 10.00% -3.68% 16.94% 3.58% 8.79% 5.31% -0.98% 5.94% 3.80%Money US US US Bank Investment Bank Money US Bank Bank
Markets Govt Govt Govt Loans Grade Loans Markets Govt Loans LoansSecurities Securities Securities Corporates Securities
5.82% 6.10% 8.32% -4.74% 8.91% 3.43% 8.30% 5.10% -2.66% 4.94% 2.65%Bank Money Money Muni Money US Money High Muni High HighLoans Markets Markets Bonds Markets Govt Markets Yield Bonds Yield Yield
Securities Bonds Bonds BondsN/A 3.45% 2.72% -6.04% 5.53% 2.16% 5.14% -0.07% -4.07% -9.71% -1.04%
* Fixed Income Sector Performance is based on Lipper sector indices. Past performance is no indication of future performance.
FIXED INCOME SECTOR PERFORMANCE, 1991-2001
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Q&AQ&A
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