Core/Satellite Investing

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1 For professional investors only Core/Satellite Investing Core/satellite portfolio construction aims to combine the most effective characteristics of index and alpha-generating strategies offering flexibility and lower costs than more conventional approaches. The broad range of market exposures offered by Exchange Traded Funds (ETFs) allows for a significant role in the implementation of core/satellite strategies, used both as efficient core investments as well as satellites.

2 ishares is the World s No. 1 1 ETF provider ishares from Barclays Global Investors ishares is the World s No.1 1 ETF provider, with over 361 ETFs trading globally, registered in 15 countries and amounting to over 254 billion 2 in assets under management. In Europe, ishares funds can be traded on exchanges in France, Germany, Austria, Italy, the Netherlands, Switzerland, and the UK. ishares funds can also be traded on Chi-X 3. The European product range has grown to encompass equity and fixed income funds as well as alternative asset classes offering both worldwide and regional exposure. Inside each asset class, ishares ETFs provide a wide range of exposures. For example, the equity ETFs universe offers broadly diversified as well as specific benchmarks like sectors, single countries and Shari ah compliant investments. In the fixed income space an investor is provided with easy and quick access to covered, government, inflation-linked, corporate and emerging markets bonds. In addition, ishares provide investors with exposure to commodities, REITS or other listed securities from alternative asset classes. ishares are managed by Barclays Global Investors (BGI), one of the world s largest fund managers. BGI, a subsidiary of Barclays PLC, currently manages over 1.1 trillion 4 in assets globally. Scale, product range and client service are differentiating factors that set Barclays Global Investors apart in the ETF market. For further information on ishares, please visit or call from Germany and Austria: +49 (0) from the Netherlands: from Switzerland: from Luxembourg: from the UK: Source: ETF Landscape, Industry Review, January 2009, Barclays Global Investors. 2. Source: ETF Landscape, Industry Review, January 2009, Barclays Global Investors. 3. Chi-X is a pan-european trading platform designed to offer efficient and cost-effective trading in European equities, including ETFs for the first time. 4. Source: Barclays Global Investors, February

3 Core/satellite investing Core/satellite investing is based on the simple concept of splitting a portfolio into two segments. The first is the core (see Figure 1 below). This forms the foundation of the strategy around which the more specialised satellite investments can be added. The core investments account for the main part of the overall portfolio, a typical allocation to the core investments would be 70%. The core usually takes the form of a low risk, pooled investment vehicle. This is typically an index tracking fund, such as an ETF, that offers low cost, broadly diversified exposure to a market or index. The aim is to deliver a return in line with the market s performance this is often referred to as the beta return. The second segment of the portfolio is made up of the satellites. These are typically more specialised investments which the portfolio manager believes will deliver additional returns (alpha). This can be achieved through exposure to specific markets, actively managed funds, investment themes, individual securities and ETFs. Satellite investments typically carry higher risk and fees than core investments. Figure 1 HEDGE FUND SECTOR/ STYLE/ SIZE EQUITY ETFs BROAD-BASED INDEX-TRACKING FIXED INCOME AND EQUITY ETFs ALTERNATIVE ETFs INDIVIDUAL STOCK SELECTION SINGLE COUNTRY/ REGION EQUITY ETFs ACTIVE FUND 3

4 The benefits of using a core/satellite strategy Risk budgeting Risk budgeting is a central part of the investment decisionmaking process. The risk budget is the maximum amount of risk an investor is prepared to take in a portfolio. The main aim of risk budgeting is to ensure that investment strategies are formulated with a full understanding of the investment risks being taken. It also aims to ensure that this risk is managed as efficiently as possible. Many different types of investors use core/satellite strategies. These include pension fund managers, wealth managers, asset managers and private investors. This broad appeal reflects a range of advantages. 1. A clear perspective The core/satellite strategy is a modular approach to portfolio construction which allows specific risk and return targets to be set for each investment. If any part of the portfolio is not meeting its target, remedial action can be taken swiftly without disturbing other elements of the strategy. This offers flexibility to the portfolio manager, and enhances transparency of risks taken and return contribution. 2. Lower overall portfolio costs By separating core and satellite investments costs can be managed more efficiently. The main cost benefit typically comes from using a cost efficient vehicle for the core element of the portfolio. In other words, core beta investments should have low fees. Satellite investments, which typically form a smaller part of the overall portfolio, can have higher fees if delivering additional returns (alpha). This concept is described on the following page with an example. The decision on what level of risk to take may prove to be the most challenging part of the process. The reason for this is that some risks are difficult to quantify, for example liquidity risk or the risk of low transparency. However, deciding on the overall risk budget available and quantifying as much of the risk taken as possible is a critical part of the asset allocation process. It will determine which assets and investment vehicles to choose and ultimately how successful a portfolio manager is in achieving high risk adjusted returns. 3. Focus on key competencies Allowing investors to focus on their competencies and outsourcing the areas with little expertise can offer enhanced returns. This is a result of lower cost structure and two principal advantages over a generalist approach: first, the ability to take advantage of other managers expertise in specific areas; second, resources are freed up to either focus on the areas in which the investor is best able to add alpha or to react to changes in market conditions more quickly. 4. Effective risk management As described above the core/satellite approach enables portfolio managers to set and control risk targets for the different investments made. Tracking error (as one possible measure of risk) can be allocated to the various investment vehicles. The larger part of the tracking error budget will be allocated to the satellite investments, assuming an index based core investment with no or very low tracking error. This concept is described on the following page with an example. 4

5 Core/satellite strategy examples The following two hypothetical examples illustrate how the core/satellite approach can be used in order to build more efficient portfolios and meet investment objectives 5. Example 1: Building a balanced portfolio Example 2: Managing costs and risk by clear separation of alpha and beta investments Initial client situation: Mid-size family office Based in eurozone Balanced portfolio The portfolio manager s core competencies are small and mid-cap stocks Client s objectives: Diversification Obtaining portfolio growth while taking a moderate level of risk 50% fixed income and 50% equities No investment in alternative asset classes No currency exposure in core portfolio Core: 70% of overall portfolio 25% eurozone government bonds 15% euro corporate bonds 10% euro inflation linked bonds 20% eurozone blue chip equities Implemented through pure beta investments in ETFs Satellite: 30% of overall portfolio Single small and mid-cap stocks Sector bets with single stocks and sector ETFs Tactical size tilting with size ETFs Result: Broadly diversified portfolio across fixed income and equities Possibility to focus on key competencies No currency exposure in core holdings Low costs of ETFs Liquidity in core holdings through use of ETFs Initial client situation: Institutional equity asset manager Predominantly investment in active funds Current overall Total Expense Ratio (TER) of target funds: 1.2% Given risk budget, measured by tracking error: 2.5% of overall portfolio value Performance attribution of active fund returns showed the majority of the return to be driven by market returns (beta) and only a small contribution of active returns (alpha) Client s objectives: Lower overall portfolio cost Optimizing the active return per unit of active risk spent Core: pure beta investment Equity ETFs with average TER of 0.35% and an annualized tracking error of 0.25% Satellite: pure alpha investments Active funds/hedge funds with average TER of 3% and an annualized tracking error of 15% Result: A combination of 85% pure beta and 15% pure alpha investments A weighting of 85%/15% optimises the tracking error budget of 2.5% Tracking error: 2.46% Costs, as measured by TER: 0.75% which is significantly lower than the initial costs of 1.2% The separation of alpha and beta allows for advantage to be taken of the core competencies of active and passive managers 5. Note: The examples do not represent investment advice and are purely theoretical. 5

6 The examples also demonstrate another direct benefit of pursuing a core/satellite strategy which is that it will encourage the consideration of a broad range of possible investment vehicles and products. Investors consider index tracking funds, actively managed vehicles, hedge funds, direct holdings of securities, as well as the various asset classes in which the strategy can be executed. Among these options, index tracking funds have enjoyed widespread acceptance as core holdings. More exotic trackers are also commonly finding homes as satellite holdings. The reasons for this success are described below. The key benefits of ETFs Flexibility Use ETFs to gain exposure to either a single market or across multiple regions or asset classes. Put their liquidity and cost-efficiency to work for both short- and longterm strategies. ETFs trade and settle like stocks, and you can buy or sell them at any time of the trading day. Performance at low cost ETFs operate on a much lower cost structure than actively-managed funds. By aiming to match rather than beat the returns of a specific index, ETFs are a highly efficient way to gain specific market exposure. Liquidity ETFs are as easy to buy and sell as individual stocks. Active market making and quick and efficient ETF unit creation/redemption processes provide the depth to handle even large institutional capital flows. Transparency ETFs are transparent both in terms of costs and holdings, they are also clear about what investors pay towards running the fund, as shown by the total expense ratio. Diversification A single ETF transaction gives an investor instant exposure to the entire target investment market, helping to spread risk more widely than buying a small basket of individual stocks. 6

7 Contact us For more information on all ishares ETFs, please visit our website on Alternatively, please call us on: From the UK: From Switzerland: From the Netherlands: From Germany and Austria: +49 (0) From Luxembourg: Regulatory Information Barclays Global Investors Limited ( BGIL ), which is authorised and regulated by the Financial Services Authority ( FSA ), has issued this document for access by Professional Clients in Austria, Germany, Luxembourg, Switzerland, the Netherlands and the UK only and no other person should rely upon the information contained within it. ishares plc, ishares II plc and ishares III plc (together the Companies ) are open-ended investment companies with variable capital having segregated liability between their funds organised under the laws of Ireland and authorised by the Financial Regulator. Restricted Investors This document is not, and under no circumstances is to be construed as, an advertisement, or any other step in furtherance of a public offering of shares in the United States or Canada. This document is not aimed at persons who are resident in the United States, Canada or any province or territory thereof, where the Companies are not authorised or registered for distribution and where no prospectus for the Companies has been filed with any securities commission or regulatory authority. The Companies may not be acquired or owned by, or acquired with the assets of, an ERISA Plan. Risk Warnings Shares in the Companies may or may not be suitable for all investors. Barclays Global Investors Limited does not guarantee the performance of the shares or funds. The price of the investments (which may trade in limited markets) may go up or down and the investor may not get back the amount invested. Your income is not fixed and may fluctuate. Past performance is not a reliable indicator of future results. The value of the investment involving exposure to foreign currencies can be affected by exchange rate movements. We remind you that the levels and bases of, and reliefs from, taxation can change. Affiliated companies of Barclays Global Investors Limited may make markets in the securities mentioned in this document. Further, Barclays Global Investors Limited and/or its affiliated companies and/or their employees from time to time may hold shares or holdings in the underlying shares of, or options on, any security included in this document and may as principal or agent buy or sell securities. ishares is a registered trademark of Barclays Global Investors, N.A. All other trademarks, servicemarks or registered trademarks are the property of their respective owners Barclays Global Investors Limited. Registered Company No All rights reserved. Calls may be monitored or recorded. 50% Recycled post-consumer content. 50% Content from responsibly managed forests. ISHARES <GO> IS-CORE-I-SNUGLA-MAR09-EN

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