Giovanni Legorano looks at how investors are retooling their core-satellite approach in the wake of financial meltdown
In these tumultuous times all investment strategies are coming under close scrutiny and the core and satellite approach is no exception. Traditionally, the core and satellite approach has enabled the managers to divide their portfolio into a core passively managed portfolio and an actively managed “satellite” portfolio. The approach is remaining popular but there are signs that schemes are looking to deploy it in a different way.
DB Advisors’ chief investment officer Georg Schuh pointed out that pension schemes manage the passive portion of their portfolio either through the use of derivatives or through underlying securities.
He explained: “In the past, passive management focused on underlying securities. We are now seeing a new trend for passive management to become increasingly complex.
“Now asset managers need to decide if it makes sense to use derivatives and assume a counterparty risk or use equities and bonds.”
In addition, Schuh said the satellite approach was under review as it traditionally has allocations to alternative investments, such as hedge funds and private equity. These have all faced great challenges this year.
He added: “There is increasing demand for a new form of satellite active management, which is based on a customised benchmark. This type of management will design the exposure on the basis of a benchmark for a specific asset class. From this specific sectors and stocks for which a downgrade is considered likely are excluded.”
Destination: fixed income
In general terms, there is no denying the financial crisis caused a fundamental change for the pension industry in that most schemes are limiting their exposure to equities and replacing it with fixed income. With this tendency towards de-risking, the bond portfolio is becoming the largest portion of the assets and, as a result, the techniques used within the equities portfolio are now used within the bond portfolio.
Against this backdrop, Mercer senior investment consultant Crispin Lace said the more fundamental change taking place was that historically the core-satellite approach had involved equity mandates, while more recently the approach has been used within bond mandates as the bond portfolio has become a bigger proportion of the assets.
In addition, Lace pointed out prior to the crisis the core portfolio was managed passively or using some form of quantitative management, while the satellite was managed with a high focus on fundamentals. However, Lace said: “Several fundamental managers managing satellite portfolios have under performed over the last six to 12 months and this has tended to dent schemes’ confidence in active management.”
As Investec managing director, cross-border distribution Richard Garland put it: “Many managers are clearly not delivering any alpha and if schemes end up with beta, they are better off without paying so much money for beta.”
Garland indicated a growing move away from active management into passive, whether it is through an index manager or through exchange traded funds (ETFs).
He added: “We will still see some interest in alpha, but it will be focused on very specialist alpha for the satellite part of the portfolio.
“Investors are starting to use currency not as a currency overlay strategy but as a separate source of alpha, looking to appoint managers to run a portion of the fund in both developed and developing currencies.
“There are clearly opportunities for asset managers offering specialist products. If you are primarily a core manager, many of the large pension funds are going to manage the core asset classes in-house or they are just going to go passive. This trend is accelerating because of the dramatic fall in markets over the last 12 months.”
Maintaining funding levels
The crisis has undoubtedly had an effect on the funding levels of schemes and that in turn has affected the way they were deploying their core-satellite approach.
Pension scheme trustees and their sponsors are focusing much more on the funding level of their schemes and the financial health of the sponsor company itself. What follows is a heavy focus on contingent funding and all this is affecting asset allocation decisions.
Fidelity International executive director of defined benefit business Mark Miller said: “There is a particular focus around toxic assets. Schemes are now extremely concerned about what hedge fund of funds managers have invested in and what the underlying strategies are. Before there was not such an emphasis.” In addition, Miller pointed out pension plans are concerned about mark to market and the liquidity in their investments and redemption issues.
He said: “Aligned with that there is a flight to quality, to stable and secure institutions. Diversified portfolios, risk management, oversight, governance, have all become very popular again.”
“There are always going to be risk and rewards. Schemes have been focusing too much on the rewards side in a bull market, while they tend to concentrate on the risk side in a bear market.”
While several schemes have chosen to drastically increase their allocation to fixed income, Miller warned significant changes had been taking place in the bond area. He said there was now a wide divergence between managers’ recent and likely future performance within the bond space, due to the fact these bonds had significant market risk and, in the short term, active strategies with an overweight in credit would outperform. Also investors should be very concerned about passive strategies that would lock investors into any and every bond default and downgrade.
According to Vanguard head of investment strategy Fran Kinniry over the last one to three years the core has become a much larger percentage of the portfolio. He said: “We have seen the satellite portfolio really come under significant performance and risk pressure due to market volatility. The satellite had much more risk, especially in a market which is highly differentiated such as in 2008 and 2009 and we have not seen excess return come from that risk.”
Kinniry said the reason was the satellites did not live up to their promise. He explained: “The idea that you take more concentrated bets that look highly differentiated from the market has not shown to produce excess returns and to differentiate and protect the portfolio in a downside environment.”
Although a number of changes to this approach took place during the last years, it is still reasonably popular within the pension funds community. Mercer’s Lace pointed out this way of structuring a scheme’s portfolio represented a very effective risk management tool. He also said it was a very cost effective way of selectively accessing alpha. He said: “In a more general mandate I can’t be as selective in identifying and exploiting the particular management skill sets I can find in an investment management organisation.
“With this type of approach, it is possible to target very carefully the skills of the manager that you want to exploit and then use the core part of the portfolio to manage your risk effectively.”
There are also effects on fees, since, Lace said, schemes would not be paying high fees across the whole portfolio, but only on a portion of it.
Kinniry pointed out this approach clearly offered the opportunity to schemes to take some risk, in order to try to outperform the market, but he also said statistics showed they had lower returns despite what they promised, but with a much higher risk involved.
He added the environment has made pension funds rethink their asset allocation, as a result of the liquidity change, and started to realise that the portfolio works very much like an orchestra with assets in concert with one another. He concluded: “If you have long-term commitments to alternatives, in order to make for the funding requirements in the future, schemes will need to sell in poor market conditions and it may also change your allocation.
“In addition, we do not see any evidence that alpha or excess return is predictable or repeatable. We see alpha as being highly cyclical and not repeatable.
“We are going to go back to best practices, to 50 years ago asset allocation, which means thinking about the portfolio holistically and, as a result, we have been and will most likely continue to see inflows into more traditional assets and diversifiers and away from the many alternatives that did not work as planned.”
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