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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:

	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