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Equity market exposure, interest rate duration, and active management are the key sources of risk and return in most investment portfolios. The core and satellite approach to portfolio construction uses passive or tax-managed core portfolios to achieve a desired exposure to equity and bond markets. Active returns are pursued through satellite strategies such as hedge funds, private equity, concentrated equity, and high yield. We highlighted the investment and tax considerations that favor a core and satellite structure in a previous article (Mulvihill [2005]). This article proceeds from the previous one and focuses on issues that arise in the implementation of a core and satellite portfolio. We suggest a general approach to three decisions:
1. choosing the core equity strategy that works best with an investor's specific tax situation
2. determining the allocation to active risk
3. selecting satellite strategies to implement the desired allocation
The analysis proceeds as follows: We first consider three different core equity strategies, differing only in their tax management policies. We show how the strategies fit with different investor tax profiles. Next, we assume a base-case portfolio that consists only of a 60/30/10% allocation to core equity, bonds, and cash. There is no allocation to active risk in this base-case portfolio. We introduce a choice of four different satellite strategies that differ primarily in their exposure to equity market returns. These vary from a diversified, actively managed equity portfolio to a marketneutral hedge fund. We use a mean variance optimization framework to identify 1) the return required to justify a 10% allocation to one of the satellite strategies and 2) the change in the allocations to core equity and bonds that best accommodates the allocation to the satellite strategy. The reallocation should produce an overall portfolio risk and after-tax return identical to that of the base-case portfolio. The satellite strategy must therefore produce as much after-tax return as whatever it displaces from the base-case portfolio.
Finally, we convert the required returns into required information ratios. The performance of active risk strategies is often evaluated in terms of the ratio of excess return per unit of active risk. This is the information ratio. An investor trying to determine how much to allocate to active risk strategies, and trying to choose among...