Core–Satellite Investing: Budgeting Active Manager Risk

Bernd Scherer

The central objective of this chapter is to show pension fund trustees how they can optimally combine the skills of both index-tracking and active fund managers. It is the most important decision after the strategic asset allocation has been derived, given the increasingly competitive nature of the pension fund market. At the time of writing, the practice is to use weight allocation to choose between managers (managers who perform well get higher weights, while others are terminated). This chapter will show that this can be considerably more inefficient than the risk allocation method, where well-performing managers are allowed to become more aggressive, while less successful managers are moved into passive management. Instead of using the weight allocation method, the suggestion ventured is to efficiently use all available information on managers, showing return histories of different lengths, as truncation would lead to an increase of estimation error and hence to allocations of little practical use. Finally, the chapter offers an estimate of the loss in efficiency if the correlation structure between managers and asset classes is not properly taken into account.

Core–satellite