Active Share: The truth about core-satellite investing
In this post, we continue the active share1 conversation by tackling core-satellite investing.
We also address the misperception that limiting active management to a small portion of the portfolio is an efficient way of achieving high active share and capturing excess returns with low fees.
Jon: Leola, will you start by defining core-satellite?
Leola: The idea of core-satellite investing, I’ll call is C-S, is to invest a material portion of one’s allocation to an index product (the core) to capture market exposure and a smaller portion of the allocation to an active product (the satellite) to get alpha. This active product is meant to be very aggressive in security selection and may have very high active share.
Jon: What happens to active share when using a C-S approach?
Leola: To keep things very simple, I will focus on two specific examples in the context of “Manager 1,” a very high active share portfolio from our second blog post of this series.
Example 1: Core-50 = 50% MSCI World Index product + 50% Manager 1
Example 2: Core-75 = 75% MSCI World Index product + 25% Manager 1
In Exhibit 1 below, we show the active share of our two examples relative to the range of active share managers in our global equity universe. The boxes range from the 25th to the 75th percentile active share scores and the lines coming out of those boxes reach to the 10th and 90th percentile active share scores. In reviewing this exhibit, you can see that without the Core-50 and Core-75 portfolios, we would have scaled the vertical chart axis to start at 50 (I’ve dropped in a red horizontal line at 50 to show where that would be). To accommodate the very low active share of the C-S strategy, far below even the 10th percentile for active manages, we’ve had to rescale the chart to start below 20!
Exhibit 1. Core-Satellite portfolios active share. For illustrative purposes only. Not representative of an actual portfolio. Past performance is not indicative of future results. As measured against the MSCI World Index for benchmark purposes.
Jon: Wow! That’s a massive re-scaling you’ve had to do. So you are telling me that C-S may result in much lower active share than multi-manager, even when one starts with a high active share manager for the satellite part. Why isn’t this well-known?
Leola: My guess is that the industry considers only the active share of the satellite manager(s) rather than the entire portfolio.
Jon: Ok, let’s get to the important stuff. What happens to excess returns?
Leola: Because we are now talking about mixing an index product with an active product, the math gets really easy2. Notice, in Table 1, that the excess return and tracking errors3 will all be approximately half. By contrast, the information ratios4 do not change.
|Manager 1||Index Product||Core-50||Core-75|
|Average Active Share||91.9%||0.0%||45.9%||23.0%|
|Average Excess Return||4.8%||0.0%||2.5%||1.2%|
Table 1. Summary statistics for Managers 1, the Index Products and Core-Satellite Portfolios
Note that in our previous blogs, we had multi-manager portfolios as represented in Table 2.
|Portfolio 15||Portfolio 26||Portfolio 1 + Portfolio 2|
|Average Active Share||85.3%||76.0%||73.6%|
|Average Excess Return||4.5%||3.0%||3.9%|
Table 2. Summary statistics for Portfolio 1, Portfolio 2, and Portfolio 1+ Portfolio 2
Jon: So the C-S approach has some pretty modest returns relative to even a five manager portfolio (Portfolio 1 + Portfolio 2). But isn’t the point of this is to keep the fees down?
Leola: Yes, of course, C-S typically results in lower fees than a portfolio with 100% active managers, but you really bring the point home with how it relates to excess return potential. You can always pay less and get less. If you pay for a Mercedes, you will get a Mercedes, and if you pay for a Ford®, you will get a Ford. There are many people who want Fords, so that is a great thing! But you can’t have a Mercedes for the price of a Ford.
1 Active share, also known as active money and/or commonality, is defined as the sum of differences between an active fund
2 We will assume, to keep all the math simple, that the index product has exactly the same returns as the published index. Actually, this is never true. An invested index replication will always deviate slightly from the published index which will result in some excess return, tracking error, and information ratio.
3 Tracking error is the volatility of excess return over time.
4Information ratio is the ratio of excess returns to tracking error.
5 Portfolio 1 = Average (Manager 1, Manager 2, Manager 3) from our second blog post in this series.
6Portfolio 2 = Manager 4 + Manager 5 from our third blog post in this series