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Home > Asset Management Best Practice > When Form Follows Function: How Core–Satellite Investing Has Sparked an Era of Convergence

Asset Management Best Practice

When Form Follows Function: How Core–Satellite Investing Has Sparked an Era of Convergence

by Christopher Holt

Executive Summary

  • Core–satellite investing involves the separation of portfolios into a passively managed “core” (conforming to a strategic asset allocation framework) surrounded by actively managed “satellites” made up of active long-only funds and alternative investments.

  • While this structure yields operational benefits, it stops short of its full potential as a portfolio construction rubric since it deals only with superficial labels (asset classes). Instead, institutional investors are beginning to think in terms of alpha (skill-based) returns and beta (index-based) returns.

  • The separation of alpha and beta, regardless of their source, is a more accurate way to view core–satellite investing.

  • This bifurcation has recently led to major changes in the way some pension portfolios are managed and in the way that asset managers service their clients. Asset classes once treated as separate or distinct are now converging into one integrated alpha/beta paradigm.

  • Though challenges remain, there is little doubt that core–satellite investing has unleashed a wave of change that is reshaping asset management.

Introduction

“It is the pervading law of all things organic and inorganic…that form ever follows function.”

Nineteenth century Chicago architect Louis Sullivan famously observed that a building’s design must follow from its functional use. The same might be said about the design of modern portfolios and their management entities (pensions, endowments, asset managers, etc.). After emerging over the past decade as a simple portfolio management rubric, core–satellite investing is leading to a wholesale reengineering of the investment management function.

Core–satellite investing can generally be described as the separation of beta-centric (core) investing from alpha-centric (satellite) investing. However, the term has become stretched and overused. Today, “core” often refers to any number of passive asset classes and even to actively managed mandates. But a more literal definition of core as pure beta and satellite as pure alpha helps to shed light on one of the most significant underlying trends in asset management today—convergence.

History

Prior to modern portfolio theory little effort was made to distinguish between active and passive investing. All investing was simply seen as active. Then, in the 1960s, the capital asset pricing model (CAPM) revealed that security and portfolio values could be expressed in terms of two distinct concepts: beta and alpha.

Still, the CAPM remained primarily an analytical technique until the 1990s, when index mutual funds and, soon afterwards, exchange-traded index funds (ETFs) provided investors with an efficient way to invest in the market passively. Advocates of the efficient markets hypothesis saw ETFs as a way to rid themselves of the scourge of active management. But, as evidenced by the continuing interest in mutual funds, many investors were not willing to give up on active management altogether. They wanted both active and passive returns, and they wanted them in a flexible and interchangeable format.

Alternative investments (hedge funds, private equity, real estate, infrastructure, and commodities), it turned out, were the ideal complement to these pure beta funds since their returns had a very low correlation with markets. Thus, a combination of a passively managed ETF and an actively managed alternative investment could be made essentially to approximate a traditional actively managed portfolio. And so the institutional example of core–satellite investing, “portable alpha,” was born.

Portable alpha generally refers to a more efficient construction of sponsor portfolios that involves access to market returns (beta) synthetically via futures or swaps, and access to manager skills (alpha) separately, usually via an allocation to a hedge fund. Separating these two sources of returns provided institutional investors with greater flexibility than ever before.

In response to this trend, the asset management industry began to bifurcate into providers of “high alpha” and “cheap beta.” As one industry supplier put it at the time:1

“The separation of Alpha from Beta is expected to shift profit away from traditional long only active funds toward the extremes of unconstrained Alpha-generating investing (more volatile pools, such as certain types of hedge funds and private equity) and passive investing (index funds, exchange-traded funds and certain types of derivatives).”

Convergence Within Institutional Portfolios

By placing the major components of the strategic asset allocation in the “core” and more active alpha-generating investments in the “satellite,” institutional investors gained flexibility and achieved cost reductions (Figure 1). For example, transitions between active managers (in the satellite) could be executed without incurring the costs of liquidating the core or hiring a transition manager. Also, by removing the benchmark constraint from satellite managers, they are free to implement a greater portion of their investment ideas.

When Form Follows Function How Core–Satellite Investing has Sparked an Era of Convergence Fig 1

Figure 1. A “converged” approach to asset management combines aspects of both the traditional and alternative investment models

While innovative, this view of core satellite investing still relied on traditional asset class labels (large cap, small cap, hedge fund, etc.), and not on the underlying characteristics of these mandates identifying them as alpha or beta.

Since their introduction in 1949, hedge funds had been viewed by investors as a separate and distinct asset class. But by the early years of the 21st century, the separation, manipulation, and recombination of alpha and beta had begun to attract the interest of large institutional investors. These investors saw alternative investments as alpha delivery vehicles first and foremost.

Innovative public pension plans such as Sweden’s AP7 (see case study) went a step further, ignoring labels such as “traditional” and “hedge fund,” and reoriented their portfolios and organizations along the lines of alpha and beta regardless of their respective sources.

As a result, asset classes that have been managed separately are now converging into one business model whose salient parts are alpha and beta, not “traditional” and “hedge fund.”

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Further reading

Books:

  • Callin, Sabrina. Portable Alpha Theory and Practice: What Investors Really Need to Know. Hoboken, NJ: Wiley, 2008.
  • Dorsey, Alan H. Active Alpha: A Portfolio Approach to Selecting and Managing Alternative Investments. Hoboken, NJ: Wiley, 2007.

Reports:

  • Engstrom, Stefan, Richard Grottheim, Peter Norman, and Christian Ragnartz. “Alpha–beta-separation: From theory to practice.” Working paper. May 26, 2008. Online at: ssrn.com/abstract=1137673
  • Hubrich, Stefan. “An alpha unleashed: Optimal derivative portfolios for portable alpha strategies.” Working paper. January 8, 2008. Online at: ssrn.com/abstract=1015327
  • Miller, Ross M. “Measuring the true cost of active management by mutual funds.” Working paper. August 2005. Online at: ssrn.com/abstract=746926
  • Thomas, Lee R. “Engineering an alpha engine.” PIMCO, February 2004. Online at: tinyurl.com/6a4jt24 [PDF].

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