A core-satellite approach using risk premium Investing - Better defining risks and skills

A core-satellite approach has often been discussed as a good intuitive approach to allocating of asset classes and active or skill-based manager. Investors should form a diversified core portfolio based on traditional market betas and then add active managers around this core allocation. Get the core right and then fold in the alpha producing satellites.

Complications arise when the active managers are represented by hedge funds which do not closely hug traditional benchmarks. Hedge funds do not generally focus on market beta, but their risks may be closely aligned with strategies that try and exploit alternative risk premiums. These risk premiums, including, carry, value, momentum are often well-defined and can be bought cheaply. Active managers, including hedge funds, can be decomposed beyond traditional betas to better define risks and alpha; consequently, a core-satellite based on risk premiums is a natural extension of earlier asset allocation approaches.

Hence, investors should think of a core-satellite approach to managing risk premiums. This approach would allow for a more refined look at asset allocation while still encompassing the core idea of traditional asset class beta.

Investors can start with core holdings of traditional betas based on asset classes, add in risk premiums that can be expressed through "smart beta" in the form of long-only investments or a set of alternative risk premiums which can be modeled and purchased relatively cheaply, and finally layer in a set of skill managers. The level of complexity will move from asset class market risks, to unique risk premiums, to alpha generating skill.

The skill manager allocations (satellites) will be for strategies that are not easily replicated, based on unique skills, focused on unique opportunities that may not be persistent, or alpha generation from non-transparent or easily described strategies that do not include core risk premiums. By their nature, these skill satellites will be rare and only added after traditional beta and risk premium allocations are constructed.

The importance of the decomposition is apparent if an investor wants good transparency and low cost with ability to associate performance with well-defined risk factors. The true satellites will be associated with the few managers who have uncorrelated unique skills that cannot be created cheaply. Picking managers without this decomposition leads to poorly defined risks and higher costs. Alpha will shrink but risk definition and composition will increase. An exercise of defining portfolios by this core and satellite approach will improve overall portfolio assessment.