The Hindu Business Line : Using core-satellite approach for portfolio construction

With the market still struggling to recoup the losses suffered in January 2008, what strategy should investors adopt to ride the next leg? This article suggests that it would be optimal to construct a core-satellite portfolio. Such a portfolio would combine low-cost beta exposure in index funds with alpha generators.

Asset prices have been wobbly for a month now, struggling to recoup the losses suffered in January 2008. We received many queries from investors wanting to know the investment strategy that they should adopt in the current market conditions.

This issue is addressed here. The current market is conducive for investors to reconstruct their portfolios. This writer believes that it would be optimal to have a core-satellite portfolio structure. The core portfolio will invest 50-75 per cent in low-cost index funds. This will give investors exposure to large-cap stocks.

The balance 50-25 per cent will be a satellite portfolio consisting of direct investment in the stock market or through active funds that can generate alpha and/or exotic beta returns. Here’s the rationale for the core-satellite portfolio.

Alpha-beta separation

Portfolio returns are derived from two sources — alpha returns and beta exposure. The latter is the return that a portfolio generates because of its exposure to the market.

Alpha is the excess return over the benchmark index that a portfolio manager generates because of her skill. All active managers charge high fees with a promise to deliver alpha returns. Unfortunately, most managers primarily deliver only beta returns.

Suppose an active fund charges fees of 2.5 per cent. Further suppose 80 per cent of the variation in fund returns can be explained by the change in the benchmark index.

The investor is then essentially paying alpha fees to a fund that largely generates beta returns.

This is primary reason for alpha-beta separation. Such a portfolio would invest in managers who passively track the index for the beta exposure.

The alpha exposure should come from managers who outperform the market. These managers will typically neutralize their beta exposure so that the portfolio is not over exposed to market risk.

Suppose the alpha manager is skilled in the mid-cap space. Assume Sesa Goa is the only stock that the manager is likely to hold in the portfolio. The stock will move due to two factors- market movement and company-specific reasons.

So, returns on Sesa Goa stock consists of market returns and stock-specific returns.

The portfolio manager will buy Sesa Goa and short the Mid-cap 50 futures such that the market returns on the stock is neutralized. The portfolio will then be exposed only to the stock-specific returns on Sesa Goa.

Alpha generation comes from market timing and security selection skill. Access to such alpha generators will be largely confined to HNIs; for such alpha managers will be engage in long-short or other such hedge-fund replication strategies.

Retail investors who do not have access to such alpha generators can instead look at exotic betas. Exotic betas are returns generated from exotic assets such as real estate (through REITs), commodities and other alternative asset classes.

It could be also be generated by applying exotic trading strategies on traditional asset classes.

Applying spot-futures arbitrage in the equity market is one such strategy. The risk-adjusted returns in exotic markets or from exotic styles can be higher than from the traditional asset markets or styles.

Core-satellite portfolio

All investors — HNIs and retail — can take beta exposure through index funds. The market has fallen 18 per cent from its all-time high.

Typically, large-caps do well when the market starts trending up. Buying large-cap index funds provides low-cost beta exposure.

Investors may prefer an open-end Nifty fund that has an expense ratio of less than one per cent.

A caveat: passive beta exposure will carry high downside risk, as the NAV will simply track the market when it goes down. Investors should spread their investment over the next three months, buying at various price points.

The downside risk to such a strategy will not be very high once the market starts trending up. The asset allocation policy will be 50-75 per cent exposure to the core portfolio and 50-25 per cent in satellite portfolio.

The asset allocation policy will depend on the risk-taking ability of the investors, which itself is a function of their age and the investment horizon.

The structure of the satellite portfolio would depend on the class of investors. HNIs can hire pure alpha generators through portfolio management services (PMS) of brokerage firms and banks and through private-equity investments. The satellite portfolio should consist of assets that have minimal embedded beta.

The satellite portfolio for retail investors will consist of exposure in specialty funds such as Infrastructure fund, Financial Services Fund, Gold fund and Emerging Market funds.

The idea is to take exposure in markets that have high level of asset mis-pricing. So, the higher returns will come from the exotic beta exposure instead of alpha generators. Such a portfolio may serve the investors well over their investment horizon.

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

B. Venkatesh

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