Optimising beta

Institutional investors may be missing out on the full benefits of a core-satellite approach to portfolio investment because they are using broad market indexes as benchmarks for the core and failing to optimise the passive part of their portfolio.

This was the central message of Noël Amenc, professor, finance department, EDHEC Business School, and director, EDHEC Risk and Asset Management Research Centre in a keynote address at the IPE awards in Paris.

“The core satellite approach according to a survey we conducted, is now recognised by most institutional investors,” Amenc says. “A majority of respondents say they will or that have practised it. Unfortunately when you look at what they are actually doing you find that they are actually using market indexes. They haven’t taken advantage of the freedom that the core-satellite approach gives them to develop their own benchmark.”

Many investors will choose exchange traded funds (ETFs) to track broad market indexes such as the DJ Euro Stoxx and S&P 500 for their the core portfolio. Yet there are alternative strategies, he says. One is holding an optimal portfolio of sector, style or country indices.

“Instead of putting a market index I can try to do something different, and there are options that allow me to do that. I’m going to look at sector indexes that have their own ETFs tracking them, style indexes that have their own ETF’s tracking them. I’m going to break down the big geographical indices into smaller regions. And I’m going to diversify.

“What I’m going to do is a fairly straightforward exercise that everybody is familiar with - optimisation - and I’m going to optimise the management of beta. I’m not trying to optimise the yield. I’m trying to reduce risk.

“The results speak for themselves. If I compare the allocation to a stock index with an optimal allocation between the components of that index , broken down by style and sector, it shows that I can reduce risk and volatility significantly on the core portfolio, in bonds as well as equities.”

Amenc says using the components of an index rather than the broad index itself will always be more effective because of diversification. “The cap-weighted index is a trend follower. It always increases the level of the risk as the capitalisation price increases, which is disastrous unless you expect the market to go up for ever. But if you think the market is going to fluctuate, a capitalisation weighted index is the worst possible tool to use.

“Even if you only equally weight you are going to get a much better performance than the cap weighted index. The minimum difference is 200 basis points over the long term.”

The other challenge facing investors who use core-satellite is to align satellite and core portfolio factor exposures, says Amenc. The composition of the active satellite should depend on the selection of a manager or managers with the highest potential for generating alpha. Yet nothing guarantees that the resulting satellite portfolio will have the same factor exposure as that of the core, which was designed to be optimal given the investor’s preference and constraints.

There is therefore the chance that a naïve selection of active managers will mess up the otherwise carefully designed factor exposure of the core portfolio, he says. “Once you have done this beta management it would be very unfortunate if you completely undermined all you had done.

“You have to be careful how you manage your satellite, because contrary what you have been told you are not just bringing alpha into the satellites. When you are buying in active management, including hedge funds, you are going to be generating beta as well.

“So you need to have the concept of portable alpha. This is bringing alpha into the satellite without undermining the very efficient allocation you have just set up.”

Two possible approaches can be followed to align the betas of the satellite with the betas of the core portfolio, he suggests. One is manager optimisation. “What you are trying to do is optimise all active managers so that at the end the proportion of beta in the satellite is the same as in the core.

“The drawback here is that manager optimisation is complicated, its not always accurate statistically and you have to be able to do it”.

An alternative solution is to use a ‘completeness portfolio’ approach, Amenc says. This sits alongside the satellite and by the use of derivatives and shorting cancels out unwanted beta.

“That way I could short the risk with ETFs, I could short less expensive risk by buying futures So I’m going to short the beta I don’t want,” he says.

The aim is to obtain investor-friendly beta exposure plus portable alpha. The approach introduces the idea of ‘portable beta’, Amenc concludes. “Portable alpha means removing or cancelling out the beta you aren’t interested in, whereas portable beta consists of introducing the beta you are interested in.”