The New Science of Asset Allocation: Risk Management in a Multi-Asset World

CHAPTER 6

Core and Satellite Investment: Market/Manager Based Alternatives

Asset allocation consists of a fundamental set of decisions centered on what investments and how much of each investment to buy given an investor’s risk preferences. This chapter provides a traditional basic “core” and “satellite” approach to asset allocation. In so doing, it focuses on the potential impact of moving from more liquid and transparent investment vehicles in each asset class to less liquid and less transparent investment vehicles and the potential change in expected return and risk associated with that movement. To reach this end, the chapter first defines the concept of core and satellite portfolios and then goes on to discuss the issues associated with benchmarking the different asset classes critical to the implementation of these concepts. Note that the research and data associated with alternative investments is relatively new and must be carefully managed. Next, the chapter provides examples of an investor’s decision making process in moving between and among core and satellite portfolios and offers an overview of sample allocations and expected risk/return scenarios. Finally, the chapter discusses recent issues in replication theory and how these developments can enhance the value of an investor’s decision.

Throughout this discussion, the chapter posits that the benefit of diversification is based on the potential for investing in a wide range of assets, each with its own unique return ...