Core Satellite Portfolios: A Sound and Proven Method to Achieve Reasonable Return with Managed Risk
The concept of core satellite portfolio construction has been adopted for several years by many investment and wealth managers. The EDHEC has collected several papers detailing this concept. ValidFi has maintained a so called Simple Core Satellite Portoflios strategy to show case this concept. In this article, we will discuss the effectiveness of combining simple timing and passive allocation to achieve better risk adjusted returns.
The key idea behind the core satellite portfolios is that, while the traditional passive (buy and hold) strategic asset allocation is suited for long term investment, the short term or intermediate term risk is too much for an ordinary investor to bear with. A portfolio with over 20% peak to trough drawdown (i.e. loss) is probably the maximum for many investors. On the other hand, an actively managed portfolio, while reducing short term risks, could suffer from a stream of short term loss. For example, a moving average based equity portfolio buys into the stock market when the stock market index such as S&P 500 index SPY rises above its 200 days moving average and sells out of the market when the index drops below the 200 days moving average. This strategy works well to protect capital during severe market downturns such as 2008's but it could suffer from loss when markets whip saw in a side way fashion. Furthermore, it could forgo a significant portion of profits when markets rise from depressed low levels. The following table illustrates correlations between the two strategies:
Apparently, these two strategies complement to each other in various market or economic cycles. Furthermore, both strategies have exhibited good long term average returns. Combining these two strategies in a portfolio should be able to maintain the long term return while reducing the risk or smoothing out the return curve.
We employed ValidFi's portfolio tool to construct core satellite portfolios based on the above two strategies. The following are three such portfolios that ValidFi now lively monitors.
The first two columns combined represent the core part of a portfolio and the last column represents the satellite (actively managed) part of a portfolio. For the stock investment, Vanguard 500 index VFINX (ETF equivalent SPY) is used and for the fixed income part, Vanguard Totoal Bond Market Index VBMFX (ETF equivalent AGG) is used.
The following table shows the characteristics of the portfolios from a period 6/30/1988 to 12/7/2009.
It is evident that core satellite portfolios not only enhanced returns (from 0.7% to 1.3% annually) but also reduced the maximum drawdown (risk) dramatically. The buy and hold portfolio had gut wrenching 42% maximum drawdown which, we suspect, very few investors had stomachs to tolerate.
The above is a simple example to utilize ValidFi's portfolio platform to construct, study and monitor composite portfolios. For investors who desire to have more diversification over various assets and strategies, such a platform could be handy.
The key idea behind the core satellite portfolios is that, while the traditional passive (buy and hold) strategic asset allocation is suited for long term investment, the short term or intermediate term risk is too much for an ordinary investor to bear with. A portfolio with over 20% peak to trough drawdown (i.e. loss) is probably the maximum for many investors. On the other hand, an actively managed portfolio, while reducing short term risks, could suffer from a stream of short term loss. For example, a moving average based equity portfolio buys into the stock market when the stock market index such as S&P 500 index SPY rises above its 200 days moving average and sells out of the market when the index drops below the 200 days moving average. This strategy works well to protect capital during severe market downturns such as 2008's but it could suffer from loss when markets whip saw in a side way fashion. Furthermore, it could forgo a significant portion of profits when markets rise from depressed low levels. The following table illustrates correlations between the two strategies:
| Early Bull | Late Bull | Bear | Side Way | |
| Passive Buy and Hold | Good | Good | Bad | OK |
| Moving Average Timing | Miss | Good | Good | Bad |
Apparently, these two strategies complement to each other in various market or economic cycles. Furthermore, both strategies have exhibited good long term average returns. Combining these two strategies in a portfolio should be able to maintain the long term return while reducing the risk or smoothing out the return curve.
We employed ValidFi's portfolio tool to construct core satellite portfolios based on the above two strategies. The following are three such portfolios that ValidFi now lively monitors.
| Buy and Hold Equity | Fixed Income (Total Bond Market Index) | 200 Days Simple Moving Average Equity (Satellite) | |
| 75% Stocks and 25% Bonds Buy and Hold | 75% | 25% | 0% |
| 30% Stocks and 40% Bonds and 30% Satellite Timing Equity | 30% | 40% | 30% |
| 25% Stocks and 25% Bonds and 50% Satellite Timing Equity | 25% | 25% | 50% |
The first two columns combined represent the core part of a portfolio and the last column represents the satellite (actively managed) part of a portfolio. For the stock investment, Vanguard 500 index VFINX (ETF equivalent SPY) is used and for the fixed income part, Vanguard Totoal Bond Market Index VBMFX (ETF equivalent AGG) is used.
The following table shows the characteristics of the portfolios from a period 6/30/1988 to 12/7/2009.
| Last 1 Years | Last 3 Years | Last 5 Years | Since 6/30/1988 | |
| Annualized Return 75% Stocks and 25% Bonds Buy and Hold | 24.3% | -1.98% | 2.42% | 8.2% |
| Annualized Return 30% Stocks and 40% Bonds and 30% Satellite Timing Equity | 19% | 4.3% | 5.7% | 8.9% |
| Annualized Return 25% Stocks and 25% Bonds and 50% Satellite Timing Equity | 20.3% | 5.4% | 6.7% | 9.5% |
| Max. Drawdown 75% Stocks and 25% Bonds Buy and Hold | 20.8% | 42.4% | 42.4% | 42.4% |
| Max. Drawdown 30% Stocks and 40% Bonds and 30% Satellite Timing Equity | 8.75% | 17.7% | 17.7% | 17.7% |
| Max. Drawdown 25% Stocks and 25% Bonds and 50% Satellite Timing Equity | 7.2% | 16.3% | 16.3% | 16.3% |
It is evident that core satellite portfolios not only enhanced returns (from 0.7% to 1.3% annually) but also reduced the maximum drawdown (risk) dramatically. The buy and hold portfolio had gut wrenching 42% maximum drawdown which, we suspect, very few investors had stomachs to tolerate.
The above is a simple example to utilize ValidFi's portfolio platform to construct, study and monitor composite portfolios. For investors who desire to have more diversification over various assets and strategies, such a platform could be handy.
Labels: AGG, Portfolio_7355, Portfolio_7357, Portfolio_7359, SPY, Strategy_374, VBMFX, VFINX, VTI
2 Comments:
Great piece. You know what would be interesting as an additional comparison: performance of a portfolio that consisted entirely of the satellite's timed holdings. Even if it wasn't superior it would show the behavior of just this component. Another twist would be to use a potentially higher returning index like Nasdaq or the s&P mid caps for the timed component. Do you have any counts on trades in and out of the market for the timed component?
Eric
Eric
It is easy: the timed component portfolio in the portfolio "25% Stocks and 25% Bonds and 50% Satellite Timing Equity" has a sub portfolio P_5763 (Vanguard 500 VFINX SMA 50 and 200 Crossover Golden Cross). You could input this symbol to the quote page and then click on Total Returns and Statistics for this portfolio to see the whole history of performance.
Since P_5763 starts on 3/31/1998, which is different from the start date 6/30/1990 of "25% Stocks and 25% Bonds and 50% Satellite Timing Equity", you could further calculate the period from 6/30/1990 to 12/7/2009 by filling the boxes on that page. Notice that it took a long time for now to calculate (we have already fixed this but have not released yet, should be in one or two days). But the Annualized Return is about 10% while standard deviation is 12%. The Sharpe ratio is WRONG in this case (again fixed and will be in one or two days).
The bottom line here is that ValidFi uses a symbol such as P_5763 to represent a portfolio and thus could build a composite portfolio using other portfolios and also treat a portfolio as a symbol just as a fund for performance and other information purpose.
We will update the above article by adding the timed component portion very soon. Thank you for your suggestion.
John
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