Right at the core
The number of European pension funds employing core satellite strategies has grown steadily. Research suggests that only 5% of pension funds were using core-satellite strategies in 1995. This had risen to 15% in 2000 and is likely to have more than doubled since the.
The attraction of core satellite is a simple one. It offers investors the best of both words - indexed and actively managed investments - and it appears to resolve the ever-running debate about which performs best, active or passive management.
The basic theory of core satellite is also simple. This is to place the majority or core of a portfolio in a broad based index-tracking fund and then seek higher returns with remaining satellite investments.
This allocation enables investors to spend their risk budgets more efficiently. By allocating a certain amount to a low risk, indexed core they will have more risk to spend on their active managers in the satellites.
The starting point is the fund’s asset allocation model. This will optimise allocations to the different asset classes, as well as to different investment styles and sizes. The core-satellite tool then allocates within each asset class to either core or index.
How it allocates will depend on the pension fund’s risk budget. The fund will choose a risk budget somewhere between a full allocation to either active and index. The volume of risk can be turned up by increasing resources to the satellite managers or turned down by allocating more to the core index fund.
There is consensus that core satellite is a sound concept. Yet there is far less consensus on how core satellite should be implemented; that is, how pension funds and their consultants should configure managers in a core-satellite arrangement.
Michael O’Brien, managing director, head of relationship management at Barclays Global Investors UK, says that there have been attempt to change or modify the configuration of managers within a core-satellite strategy. Some have been more successful than others.
One attempt has been to differentiate managers within the satellite rings in terms of their investment style, he says. “There was a sort of replication of the US core satellite structure which tries to divide managers into style buckets – value, growth, large cap, mid cap and small cap. That hasn’t worked very well in the UK because managers themselves don’t lend themselves to being heavily style bucketed.”
The other development, into unconstrained long only equity strategies, which has been strongly promoted by international consultants and its success has yet to be seen, he says.
“What we are seeing within the core satellite concept is a strong endorsement of unconstrained long-only, where basically managers are being told to disregard the benchmark.
“That is a natural extension of the core satellite structure, with the satellite being redefined within unconstrained long-only.”
Core satellite has moved further up the risk curve with the incorporation of alternative investments – in particular hedge funds and funds of hedge funds. These can be used as strategic investments. and within the strategic asset allocation, they can be considered as a cash benchmark with a cash plus target. Some of the larger pension funds like the UK’s RailPen Investments are currently using hedge funds in this way.
Alternatively, hedge funds can be used as satellite investments. The simplest way is through derivatives, says O’Brien. “You can incorporate them into whatever asset class you want through the use of derivatives because you can always equitise cash. If you’ve got a hedge fund that’s giving you Libor plus 10 you can spend a few basis points and buy an S&P 500 future and suddenly you’ve got US equities plus 10%.”
Yet hedge funds have introduced a few problems to core satellite strategies, principally because of various biases – market and structural – and the general lack of transparency. Hilary Till, strategic adviser for Prism Analytics and the co-founder of
Premia Capital Management, suggests that fiduciaries (pension funds, foundations, endowments and other institutional investors) are not being given enough information about the hedge fund investments they are incorporating in their core-satellite strategies.
In a study published in the Singapore Economic Review earlier this year, Till points out that diversified funds of hedge funds currently have a structural bias to small cap and value equity styles. This could cause problems if they are added to core-satellite portfolios that already incorporate value and small cap, she says:
“Fiduciaries who are considering adding these classes to satellite ring of their portfolios should consider the possibility they would be double counting existing asset class exposures.”
She warns that the fiduciary “must receive enough information about a managers’ strategies and key risk factors so that the fiduciary is in a position to properly understand how the satellite ring’s investments interact with the risks of their core portfolio.”
One problem with core satellite strategies is that they do not guarantee that a portfolio will not under perform. One solution to this is the so-called ‘dynamic core satellite’, a tool that can be used to guarantee positive tracking error.
This concept of dynamic core satellite was introduced by Noël Amenc, professor of finance at Edhec Business School and director of the Edhec Risk and Asset Management Research Centre in Lille.
Amenc points out that when investors allocate their investment between the core and the satellite they generally do not know whether they will get a negative or positive tracking error.
“The idea of dynamic core satellite integration is to integrate the distinction between good and bad tracking error in the apportionment of the core-satellite of the investments and therefore allow optimisation of the size of the satellite,” he says.
To achieve this Amenc and his colleagues have adapted the ‘cushion’ method of the constant proportion portfolio insurance (CPPI) technique to the core satellite approach to provide a ‘guarantee’ of positive tracking error.
The mechanism is the same as CPPI, shifting assets to ensure that performance doers not fall below a floor or cushion. “When the satellite outperforms the benchmark, we increase investment in the first to the detriment of the second, whereas when the satellite underperforms the benchmark, we reduce its share in the portfolio to avoid falling below the ‘guaranteed’ tracking error value.”
This enables a portfolio’s performance to be improved by more than 200 basis points with diversified management, says Amenc.
These refinements of core-satellite configuration, however, may not receive the attention they deserve from institutional investors. In the face of new regulatory pressures in Europe, interest has shifted to a reconsideration of the strategic asset allocation.
BGI UK’s O’Brien says: “At the moment a lot of the activity in the UK and the Netherlands is spent reassessing overall strategy, given that a pension fund’s benchmark has now become its liabilities marked to market.”
“So core satellite manager configuration has to some extent taken a back seat in the past six to nine months. At the end of the day you may have the most complex and rational configuration of managers on the face of the earth, but if you’ve got the wrong asset mix it could be akin to rearranging the deckchairs on the Titanic.”