“Core-satellite” investing is often regarded as a precursor to portable alpha and various other modern portfolio construction techniques. However, the popular definition of the term usually refers to a passive “core” and an active “satellite”. And as we have argued extensively on these pages, active management too often contains a large amount of embedded beta. Ideally, in our view, core-satellite would involve a beta core and a (pure-) alpha satellite.
This is essentially the same argument presented in a recent paper by Swiss researchers called “What if alpha is just polished beta?“. The study was authored by Erik Wallerstein, Nils Tuchschmid & Sassan Zaker – the authors behind a paper we covered last week on the performance of hedge fund replication products.
The trio question whether funds of hedge funds should even be in the high-alpha “satellite” allocation in the first place. They reason that if funds of funds can be replicated passively, then they should be disqualified from being satellites and should instead be treated as part of the core (beta) portfolio.
They use a simple linear model with 5 factors (the Russell 2000, the MSCI EAFE, the Barclays Agg, the GSCI and the CBOE S&P 500 BuyWrite Index) to replicate the HFRI FoF index. As you might guess, they find this to be the case. In fact, check out the tiny tracking error of this simple model (click to enlarge):
So should funds of funds, by virtue of their replicability, be considered “core”, not “satellite”? As the authors note:
“It should be obvious to the reader by now that fund of funds is significantly exposed to bond, equity and commodity risk. Even more, these extracted exposures are able to fairly well replicate the average performance of fund of funds. This poses some serious questions on which role fund of funds can play in the investor’s portfolio.”
They compare three “satellites”: a portfolio of real funds of funds, a clone – as per above, and a pure alpha overlay made up of a long position in the former and a short one in the latter. A mean-variance optimization was run on combinations of each satellite plus a core made up the S&P 500, EAFE and bonds.
The optimization concluded that when the funds of funds or the clones were added to the plain vanilla core, one should allocation over 100% to the so-called satellite. This is a far cry from the 5-10% routinely touted as the ideal allocation to funds of funds.
The optimization suggested a two-thirds allocation to the satellite when that satellite was defined as the alpha-only (inexplicable) portion of the funds of funds.
The bottom line, say the authors:
“These are not sufficient alpha generators to be considered as a satellite asset…This suggests that funds of funds on aggregate do not contribute with new sources of uncorrelated returns but rather classic, slightly time-varying, risk exposure. This is by itself either a strong argument against the prevailing asset allocation idea that fund of funds should only be given a marginal allocation or a clear indication that fund of funds on average do not expose their investors to enough ‘pure alpha’.”
Translation: On average, funds of funds portfolios are “polished beta”, not alpha, and should therefore be considered “core” not “satellite.”