To assess the performance of this approach, Edhec simulated 1000 scenarios covering January 1999 to December 2008. A defensive European government bond portfolio was used in the core and large-cap equity in the satellite. The starting period for the analysis marks the first instance that government bonds were denominated in euros. The 1000 scenarios are supposed to reflect the performance by 1000 hypothetical active managers who have a given hit ratio or the instances in which the satellite outperforms the core over a twelve month period.

 

The higher returns in the table above result from a dynamic asset allocation policy that shifts more money into the satellite portfolio when it outperforms the benchmark. This is because the out-performance results in a higher cushion and allows for a more aggressive investment strategy. If the satellite underperforms the benchmark, the strategy shifts more money into the core portfolio, leading to a smaller tracking error.

As a new risk budgeting technique, however, core-satellite poses a number of challenges. The decision to reallocate funds between core and satellite depends on a number of factors, either difficult to control or forecast. The most obvious challenge is liquidity. Any re-allocation among passive and active managers presumes the ability to transfer funds in and out. This is less of an issue with long-only large-cap equity funds; however, small caps and emerging market equity can prove to be less liquid. In addition, private investments and many hedge funds are typically structured with liquidity clauses, making the dynamic re-allocation among managers difficult and shrinking the available universe of investments for the satellite segment of the portfolio. Implementing a dynamic core-satellite approach can be more difficult during times of crisis when even traditional asset classes prove to be less liquid. Even the use of ETFs for alternative asset classes can present challenges: how does an ETF offer intra-day liquidity on products that are computed only quarterly in the case of real estate, and monthly in the case of hedge fund indices?

Assigning weights to the core and satellite based on historic performance presents another challenge. Edhec suggests re-balancing the portfolio on a monthly basis based on historic data. While this has proven to limit risk in the sample period, it also raises the question whether investors should not maintain a longer than one-month horizon in relation to the performance of one of their active satellite managers. Some may argue that Edhec’s monthly rebalancing leaves little room for longer-term strategic investing.