On Core and Satellite Approach to Hedge Fund Investing

A typical core and satellite portfolio approach involves investing in a “core” passively managed portfolio, and a “satellite” actively managed portfolio. The “core” is typically an index-tracking portfolio whose returns are driven by exposure to specific risk factors. Unfortunately, broad hedge fund index clones, that are currently being sold as “core” risk exposures are not exactly that. As I argued in my previous post, these clones attempt to replicate a mix of “cloneable” and “non-cloneable” funds, i.e. they are in fact “core” and “satellite” portfolios rolled into one product, with no transparency on the exact mix.

For example, figure 1 shows the Goldman Sachs Alternative Return Tracker (GS ART) index clone portfolio (Bloomberg ticker USDARTIUSD), and its performance vs. the S&P 500 index during 2005-2012. It seems that GS ART is a pretty good investment, with much lower risk and higher Sharpe ratio compared to the S&P 500!graph1

However, a better approach would be to clearly separate the “true core” and “satellite” portfolios according to the methodology of “cloneable” and “non-cloneable” funds. The “true core” should be an ETF clone portfolio that replicates only “cloneable” hedge funds, while the best “satellite” portfolio would be the one comprised of “non-cloneable” hedge funds run by truly talented managers. This way the “true core” provides investors with pure exposure to the alternative risk factors chosen by hedge funds, while the “satellite” portfolio reflects the truly active management style of talented hedge fund managers. Figure 2 provides the comparison of such “core” and “satellite” portfolios with the broad HFRI hedge fund index from 2005 to 2012.graph2

Notice that the HFRI performance roughly resembles a mix of risk-and-return profiles of the “core” and “satellite” portfolios. Overall, the 50/50 “core-satellite” strategy could be a good choice for an investor who seeks a balance between high returns and moderate risk (see figure 3), delivering the Sharpe ratio of 0.15. The 50/50 “core-satellite” strategy clearly outperforms the GS ART, as it delivers both the higher Sharpe ratio and the higher overall return.graph3

Most important, the above “core-satellite” approach has the transparency and the flexibility between the “core” and the “satellite” parts, which is missing in the broad hedge fund index clones, like GS ART! For example, an investor can choose different weights (say, 70/30) based on his or her individual preferences for risk, return, and correlation with “traditional” investments. And that’s “core and satellite” approach done right!