In the financial services industry, there is growing recognition that the design and structure of equity portfolios with multiple managers should be fundamentally different for a taxable investor than for the typical institutional investor. The presence of taxes, shorter time horizons, and higher trading costs are just a few of the factors that distinguish these investors. Many have observed that taxable investors can reap significant benefits by adopting a core-and-satellite portfolio structure rather than the typical style-bucket approach used for institutional investors.
A core-and-satellite structure usually consists of an index-like core manager surrounded by satellite managers who are seeking to add value, or alpha. The core manager anchors the portfolio to a target benchmark (perhaps the S&P 500), and the satellite managers have the freedom to take on added risk in their quest for alpha. In addition, a core manager who is actively managing taxes and opportunistically harvesting losses can reduce the tax burden of the satellite managers. If well designed, the core-and-satellite structure can increase after-tax returns, reduce risk, or both.
But how much should one allocate to the core and satellite components? The answer depends on the expected alpha of the satellite managers, the risk, and the taxes that they incur. We have studied this question in some depth (a more detailed analysis is soon to be published in The Journal of Wealth Management), and have found that many taxable investors would be well served by core allocations that exceed 50%.
Our study mathematically models a core-and-satellite portfolio. The goal is to find the allocation to the core that results in the best risk-adjusted after-tax return over a specified period. In the study, the core manager shadows the pretax return of the market index while generating tax losses. The satellite managers have positive pretax alpha: They earn an annual return above the market index, but generate capital gains. Capital losses from the core (we estimate the amount of these from past experience and from detailed computer simulations) are used to offset the gains from the satellites. Any excess losses that the core produces are carried forward and ultimately lost if not used. The risk of the portfolio, as measured by tracking error, is modeled by combining the risks of the component managers.
Risk-adjusted performance is measured as the after-tax information ratio, i.e. after-tax alpha divided by tracking error. We seek the allocation to the core which maximizes this information ratio.
Below is a sample case (Chart A) using the following parameters (all are per year):
- The market return is 8%
- The time period is 20 years
- The satellite alpha is 2%
- The tracking error of the core is 1.5% and that of the satellites is 2.0%
- The satellites realize capital gains based on annual turnover of 50%
- The short-term tax rate is 38.6%; the long-term tax rate is 20.0%
Chart A shows how the information ratio (left axis) changes as we increase the core allocation. The after-tax alpha and tracking error (right axis) are also plotted.
With no core, the satellite managers would see their pre-tax alpha of 2% drop to 0.5% after taxes. As the allocation to the core increases, the after-tax alpha increases because realized losses from the core absorb the tax costs of the satellites’ realized gains. However, as the core allocation continues to increase, the satellite alpha is diluted. If we go too far, the value of the excess tax management becomes trivial and the alpha continues to decline.
Note that portfolio risk (tracking error) decreases as the core allocation rises. This is because of the more tightly tracking core. Ultimately the portfolio risk bottoms out and rises again because we have assumed that the excess performance of the portfolio components are uncorrelated–an allocation to both core and satellites increases diversification and helps reduce overall risk.