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Core/Satellite Portfolio Construction

Core/Satellite Portfolio Construction. Budgeting for Active Manager Risk. Agenda. What is Core/Satellite? Asset allocation policy & active manager risk budgeting Implementation Example. 10 largest US defined benefit pension plans. Source: Nelson’s Directory of Plan Sponsors, January 2001.

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Core/Satellite Portfolio Construction

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  1. 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.

  4. Top managers ranked by worldwide institutional assets Source: Pensions & Investments, May 2001 Source: Pensions and Investments, May 2001.

  5. Institutional strategy evolves toCore/Satellite “Core/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 Active managers (Satellites) Index ETF (Core)

  6. Overall strategy starts with asset allocation policy InternationalStocks Small CapUS Stocks Potential return % Large Cap US Stocks Long Term Treasury Bonds Treasury Bills 0 Risk %

  7. Overall strategy starts with asset allocation policy “Optimization” combines historical returns with expected future estimates, using asset class benchmarks to create an “efficient portfolio”(hypothetical illustration) MSCI EAFE “Optimized Portfolio” Potential return % Russell 2000 Russell 1000 Lehman Bros.Gov’t/Credit Treasury Bills 0 0 Risk %

  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

  9. 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 active return % +3 +2 +1 Potential return % Potential active risk % 2 4 6 -1 -2 Russell 1000 -3 0 Risk % There can be no assurance that an investment strategy based on the core/satellite hypothetical analysis will be successful.

  10. Active Manager Risk Hypothetical Large-cap growth manager historical selection alpha vs. Russell 1000 Growth 5.1% Avg. Annual Tracking Error 1.26% Avg. Annual Alpha Positive alpha Russell 1000 Growth Alpha % Negative alpha 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Active manager tracking error 9 For illustration only. Not indicative of any investment or manager.

  11. Lower Active Manager Risk HypotheticalUsing Risk Budgeting Large-cap growth manager historical selection alpha vs. Russell 1000 Growth 2% Risk Budget = 2% Avg. Annual Tracking Error Alpha % 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 All active portfolio Portfolio with a 2% risk budget implementing active and index managers 10 For illustration only. Not indicative of any investment or manager.

  12. A Model of Active Manager Returns Tracking Error — Standard Deviation of a Manager’s Selection Alpha 1/6 of time positive selection alpha is +5.1% or more (1 out of 6 Years) Illustration of 5.1% Hypothetical Tracking Error +5.1% Benchmark Return 2/3 of time selection alpha falls within this range (4 out of 6 years) -5.1% 1/6 of time negative selection alpha is –5.1% or more (1 out of 6 years)

  13. 2% Risk Budget +2.0% -2.0% A Model of Active Manager Returns Tracking Error — Standard Deviation of a Manager’s Selection Alpha 1/6 of time positive selection alpha is +5.1% or more (1 out of 6 years) Illustration of 5.1% Hypothetical Tracking Error +5.1% 2/3 of time selection alpha falls within this range (4 out of 6 years) Benchmark Return -5.1% 1/6 of time negative negative alpha is –5.1% or more (1 out of 6 years)

  14. Real world comparison Actively managed funds that underperformed their index before tax (and after tax) • Past performance is no guarantee of future results 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.

  15. Before fees and costs After fees and costs +5.5% +4.5% “Good”Managers Benchmark =Mgr. Avg. Benchmark Mgr. Avg. = -1% “Bad”Managers -5.5% -6.5% 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.

  16. 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

  18. Implementing large-cap US equity managers An example • The real question: • How much active risk is too much? Moderate risk Index fund 65% Active mgr 35% 5.5 Alpha % 2 4 6 8 Tracking error % Benchmark (Russell 1000) 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

  19. Implementing large-cap US equity managers An example • Risk control “dial” controls the mix of selected managers Higher risk Index fund 20% Active mgr 80% Moderate risk Index fund 65% Active mgr 35% 5.5 Alpha % 2 4 6 8 Tracking error % Benchmark (Russell 1000) How much active manager risk? Source: BGI analysis.

  20. Core/satellite active risk budgeting can be applied independently across asset classes Higher active risk Index fund 20% Active mgr 80% Lower active risk Index fund 65% Active mgr 35% Potential returns % MSCI EAFE Russell 1000 6% Active Risk Budget 2% Active Risk Budget 0 Risk %

  21. 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

  22. 在經濟週期中﹐尋找投資契機

  23. 全球產業輪動 行業輪動 最差 .......… 行業績效表現 .......… 最佳

  24. 全球債市輪動

  25. Q&A • Thank You!

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