Core Satellite - A Way to Step Into Tactical Asset Allocation

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Includes: AGG, BND, DBC, EEM, EFA, IYR, SPY, VEU, VNQ, VTI, VWO
by: MyPlanIQ

Buy and hold asset allocation has become an almost unquestioned doctrine of long term investing. The emergence of modern portfolio theory in conjunction with a long bull market seemed to prove it largely infallible.

However, recent market events have put the approach under pressure and many are considering buy and hold insufficient without some additional hedges based on what we have seen and learned.

The comparison of returns from strategic and tactical asset allocation over the last five years clearly shows the dilemma. There is a significant benefit to having a tactical component to any portfolio.

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Comparison of returns between strategic and tactical asset allocationClick to enlarge

Some may still be suspicious of momentum based investing and while buy and hold has clearly had problems over the past five years there is still reluctance to move. A core satellite strategy where some of the portfolio is tactically managed and the balance is buy and hold may be a good compromise for those wanted to dip their toe into momentum based portfolios.

We have used SIB portfolios to demonstrate the benefit of asset allocation. SIB’s are made up of the market index funds so that there is no special sauce in the fund selection. We are going to extend the use of SIBs to create core satellite portfolios and compare their performance properties against a pure strategic and pure tactical asset allocation of the same fund base.

The portfolios will have six asset classes as they have an optimal level of performance traded off against the effort to maintain a large number of asset classes.

Index Funds Asset Class

Ticker

Name

Large Blend

VTSMX

Vanguard Total Stock Mkt Idx

Foreign Large Blend

VGTSX

Vanguard Total Intl Stock Index

Diversified Emerging Markets

VEIEX

Vanguard Emerging Mkts Stock Idx

Real Estate

VGSIX

Vanguard REIT Index

Commodities Broad Basket

DBC

PowerShares DB Commodity Idx Trking Fund

Intermediate-Term Bond

VBMFX

Vanguard Total Bond Market Index

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ETF Asset Classes

Ticker

LARGE BLEND

VTI, SPY

Foreign Large Blend

VEU, EFA

Diversified Emerging Markets

VWO, EEM

Real Estate

VNQ, IYR

Commodities Broad Basket

DBC

Intermediate-Term Bond

BND, AGG

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We are going to compare five portfolios:

  • Tactical Asset Allocation only with 40% in fixed income

  • Strategic Asset Allocation only with 40% in fixed income

  • 50/50 Strategic/Tactical 40%

  • 60/40 Strategic/Tactical 40%

  • 70/30 Strategic/Tactical 40%

Building and maintaining a core-satellite portfolio can be labor intensive and error prone or expensive to outsource. The MyPlanIQ system enables an individual to rapidly build and maintain a model core-satellite portfolio and be able create historical results. This is how the comparison was achieved in this case.

Screenshot of how to simply build a core-satellite portfolioClick to enlarge

The screenshot shows how to assign a percentage of the portfolio to strategic and tactical asset allocation and then examine the performance of the portfolio. In this case, it is 70% strategic and 30% tactical asset allocation

Intuitively we would expect to see tactical asset allocation giving us the highest returns with, perhaps a little more volatility and the hybrid portfolios giving a range of returns and volatility.

Portfolio Performance Comparison

Portfolio Name

1Yr AR

3Yr AR

5Yr AR

Six Core Asset Index Funds Tactical Asset Allocation Moderate

10%

9%

14%

50-50-6SIB Core Satellite

11%

6%

11%

60-40-6SIB Core Satellite

11%

5%

10%

70-30-6SIB Core Satellite

12%

4%

10%

Six Core Asset Index Funds Strategic Asset Allocation Moderate

13%

2%

7%

Click to enlarge

Full comparison

Comparison of Core-Satellite PortfoliosClick to enlarge

The results are much as expected with tactical asset allocation and strategic asset allocation bounding performance ranges and the core satellites filling in the middle.

The draw down ratios also behave as expected.

Portfolio/DD
1 Yr
3 Yr
5 Yr
Inception
TAA
10%
12%
14%
14%
50-50%
9%
24%
24%
24%
60-40
9%
27%
27%
27%
70-30
8%
29%
29%
29%
SAA
8%
39%
39%
39%
Click to enlarge

The concept of a core-satellite portfolio may appeal to many. The problem of constructing an measuring such a portfolio has been greatly simplified with analytical tools such as the MyPlanIQ system.

Takeaways

  • In the current market conditions, tactical asset allocation still provides the best performance and has the lowest risk

  • Those who want to move cautiously into momentum based portfolios can use core-satellite to dip their toe into the water

  • ETF’s are an ideal, low cost vehicle to construct a core satellite portfolio

Disclosure: No positions