[MUSIC] Hi there, in this set of video we're going to have a look at two strategies. Two ways to build your portfolio. One is the core satellite approach or core satellites approach. And the other one derived from this method is what we call, portable alpha. We'll see how they work and what are their respective merits. So starting from a core satellite, how does it work and why should we use it? Well, the core satellite approach rests on the idea that you should combine two types of strategies within your portfolio. In the core, you should use what we call index funds, or passive funds. IE, funds which replicate a market and do not try to beat it. That's the idea. If you don't believe that markets can be beaten, can be outperformed, then you should use an index fund or a passive investment. So, basically in the core you find all the assets which are deemed efficient. In the satellite, you will include active managers who are trying to beat the market in segments which are thought to be inefficient. So that's the idea. You want to combine A core which will be made of passive investment with some satellites which will be made of active investments or funds. What is the idea? Well, the idea is that you should lower the fees of your portfolio. Basically, we know that index funds or trackers are less expensive than active funds because obviously, in this case you have to pay more to excess the talent of the manager to be able to beat the market. So if you put in your core portfolio this passive of instruments, you will obviously lower the cost. So that's the idea of this whole method, is to reduce the cost and also improve the diversification. We know that if we include a core portfolio and some satellites which are poorly correlated to the core, we know that this actually improves the risk return profile of your portfolio. So now, lets have a look at two examples of core satellite approaches. So, in this first example, we have a look at the core satellite approach at the macro level. Here, in the core, and this is for US based investor, you find, I would say, traditional assets deemed to be efficient. US large cap, small caps, we may discuss weather they should possibly in some segments at least belong to the alternatives. But let's say that even the US small cap segment is deemed to be efficient. International large CAP, global investment grade, here we're talking about bonds. Okay, so these are all we say, classic asset classes and they found their way in this core portfolio. And you see all this satellites around the core. You see international small cap equities which are known to be less efficient than in the US, because probably less research, emerging markets and so forth. And we also see, on the left part of the satellites, what we call alternative. Strategies here, private equity, hedge funds, private real estates are known to be very poorly ideally, very poorly correlated to the traditional asset classes. So that's the justification, indeed if there's one asset class which should belong to this satellite approach. This core satellites and be in the satellites, it's these. Because these are known to be poorly correlated. So they do improve the risk return profile of your portfolio due to this poor correlation. So this is one example. In the core, you put traditional assets and in the satellites, you have more special assets classes which are known to be less efficient and/or poorly correlated. Another example of a core satellite approach, would be within a single equity fund, or equity portfolio. And here, it's the same idea. You will decompose your portfolio into two buckets, and the first one say, 70% of the total portfolio, you will include traditional stocks. There will be large cap, there will be strong brands, stable returns, stable earnings, defensive characteristics. What do we mean by that? Like pharma, food, infrastructure, which are known to be less sensitive to the business cycle and more stable. So here then, once you've identified these best sector and industries, you use the best in class approach to identify the best companies within each sector. And here, you may focus on various evaluation metrics like return on capital employed. Being higher than the cost of capital, or you may also look at what we call GARP, growth at reasonable price. So what you are paying for the company comparing to what it's delivering in terms of growth, so P/E to growth, for example. So once you have this core portfolio, you move to the satellite part of your portfolio, and that's the 30% remaining. And here you see, still talking about an equity portfolio, you will be focusing on more niche players. These will be small to mid cap companies. They will be under research, so that opens the doors to inefficiencies. They will have cheaper evaluation than the companies you have in your core portfolio. Would be niche players as I just said. And ideally, also have low correlation to the market index. Okay, so in this part of the portfolio, you need more creativity, you want to find some companies which are not typical. Which has not been known for many, many years and who belong in the core part of your portfolio. Now, an extension of the core satellite approach, is what were called portable alpha. Now how does portable alpha work? Basically, you start from the division we've just seen between core and satellite, or even better, satellites. Okay. Then, the next step, one step beyond this course at a lot of approach is basically, you say, okay, in the core I have my market exposure. If we're talking about this course satellite approach at the micro level. And you may want to hedge this part of your portfolio, the core bucket against a fall of the market. So in the case of portable alpha, what you do is you make a decision that you do not want to suffer on the core part of your portfolio, if the market drops. So what you will do is you will use instruments, which we'll see in another course. Called future is an option, and these instruments will enable you to hedge that part of the portfolio against a drop in the market. So basically, what you'll end up in here is a portfolio which has what we call a zero beta. We would see also in the next course what we mean by alpha and beta. But just to give you a prior first view into these two concept, basically, alpha is the performance that an active manager is making beyond the beta return, which is the market return. So anyhow, the beta measures also the sensitivity of your portfolio to the market. And what we have with this portable alpha method is basically, you have a beta of zero. IE, whatever happens to the market, you don't have any exposure to that because you've hedged your exposure. You're only left with positive alphas, which you ideally derive from your satellite. Remembering, Googling these terms, like portable alpha, core satellites, this all looks a bit mystic, right? And I bumped into this analysis from a CFA students that put a chart, and I reproduced it here. The chart of yin and yang. And he said basically, core satellite and portable alpha, that's a bit like finding the yin that balances your portfolio, yangs. Okay, the yang is the male, the yin is the female as I'm sure you know. I'll let you decide which ones should be in the core, enjoying the stability of the core and also, enjoying the fact that it is surrounded by a few satellites. In conclusion, the core satellite approach enables investors to separate their portfolio into what we call market related movement, and outperforming assets. Which typically and ideally, should be uncorrelated to the core. The core satellite approach helps you to lower the fees. Basically here, the key idea, is that you do not want to put in the core what we call closet active managers. IE, managers who pretend to be active, but indeed, in reality, they are just replicating the market. So the idea, the whole idea with this core satellite approach is that, you do not want to pay alpha fees for beta funds, or for beta management. IE, you want to, for this beta management use passive funds or index trackers. And you want to reserve the fact that you're paying alpha fees which are more expensive because here, we're talking about active management. You want to keep that just for the satellites. Portable alpha goes even one step beyond because in this portfolio of core assets, you're edging the risk that they may fall in price. [MUSIC]
