Using a Core and Satellite ETF Strategy to Generate Alpha

Investors can build core portfolios with balanced equity and fixed-income exposure, then overweight particular sectors or countries to generate alpha.

Ben Shepherd – Global ETF Profits

The great thing about exchange-traded funds (ETFs) is that they provide one with instant diversification and exposure to the overall market – whether it is a stock, bond, or commodity index – at rock-bottom costs.  After reading academic study after academic study that demonstrates how the vast majority (80%) of actively-managed mutual funds underperform the overall market, it feels like a victory to be able to match the overall market. Furthermore, the 20% of funds that outperformed in a past time period were almost never the same 20% of funds that would outperform in a future time period.  Consequently, one study concludes that:

While every period under review had mutual funds that outperformed the passive strategy, few funds did so consistently. Predicting in advance which mutual funds would outperform was difficult, if not impossible, and the cost of selecting the “wrong” manager was high.

John Bogle Says Stick with Index Funds

This conclusion matches the conclusion of Vanguard founder John Bogle, who wrote in his book Common Sense on Mutual Funds:

Funds with past relative returns that have been substantially superior to the returns of an appropriate market index will regress toward, and usually below, the market mean over time. There remains no evidence — none — that superior past performance is predictive of future success.

The most glaring proof of this principle is the record of Legg Mason Value Trust. It outpaced the S&P 500 for 15 consecutive years (1991 to 2005), only to fall behind the index by an astonishing 43 percentage points from 2006 to 2008.

Given these findings, most investors would do well to eschew actively-managed funds and minimize their costs and buy ETFs that match the market.

I could end the article here, but I haven’t satisfied my word count, so let me talk a little about alpha.

Are You an Alpha Personality?

Alpha is the holy grail of investing — some would say the mythical grail. It’s such a popular term in the investing world that an entire website is named after it: www.seekingalpha.com. I like the website’s name because it emphasizes the “seeking” part, rather than the “obtaining” part. Everybody seeks alpha but few actually obtain it. 

What exactly is this mysterious thing called alpha? It measures the degree, if any, by which a fund is beating the market on a risk-adjusted basis.  The “risk-adjusted” part of the definition is crucial to determining whether a portfolio manager actually possesses any extraordinary investment skill. After all, in any given period of time, certain investment styles are always beating the overall market. For example, over the past three years an index of gold stocks has beaten the S&P 500 by more than 42 percentage points:

Source: Bloomberg

Does this mean that a portfolio manager who invests only in gold stocks is skilled at beating the overall stock market? For heaven’s sake, no! Gold stocks are one of the most volatile (i.e., risky) asset classes. According to financial theory, higher risk requires higher returns. Consequently, a manager of gold stocks that beats the S&P 500 is not skilled; he simply assumed more risk.

Alpha, Beta and R-Squared Oh My!

Alpha incorporates this added risk in its formula and penalizes the manager on a risk-adjusted basis. The formula for alpha is:

Actual portfolio return – beta * benchmark index return

Oh boy, I’m defining one Greek term by introducing another Greek term!  Sorry about that, but it can’t be avoided.  Beta is a measure of the degree to which a portfolio is more or less risky than the benchmark index. A beta of 1.0 means that the portfolio has the same risk as the benchmark index. A beta greater than 1.0 means the portfolio is assuming more risk and a beta less than 1.0 means the portfolio is less risky.

Alpha and beta are only relevant measures if the portfolio and benchmark index it is compared against behave similarly and move in sync (i.e., their price graphs move tightly together).  This is measured by a statistical term called R-squared. According to Morningstar, alpha and betas are only meaningful if the R-squared between the portfolio and the benchmark is greater than 80%.  In the case of gold stocks, the R-squared with the S&P 500 is under 30%, so the S&P 500 is an inappropriate benchmark index and the associated alpha is not meaningful.

The Morningstar website provides data on each actively-managed mutual fund’s S&P 500 alpha, but I ignore it because it can be very misleading. I only care about a fund’s “best fit index” alpha. Below are examples of small-cap mutual funds that have a positive S&P 500 alpha combined with a negative “best fit index” alpha. I do not consider the managers of these funds to have any real investment skill:

And, conversely, here are examples of large-cap value mutual funds that have a negative S&P 500 alpha combined with a positive “best fit index” alpha. These fund managers probably do possess some investment skill:

Source: Morningstar

Hedge Your Bets: Combine ETFs with Alpha Seeking

Ok, with all this background information out of the way, I’m finally able to explain how ETFs can be used to generate alpha – assuming that alpha is not a myth. Based on the beginning of my article, I wouldn’t blame you if you think that alpha is a fantasy, so feel free to stop reading now. However, if you are one of those dreamers that seeks alpha, read on.

Some parts of the capital markets are more efficient than others. For example, the chances of finding a U.S. government bond manager or large-cap stock manager that can beat its benchmark index over the long term are virtually nil, whereas the chances of finding a market-beating manager of small-cap emerging market stocks is relatively higher.

An all-or-nothing investor seeking alpha would invest his entire portfolio in actively-managed funds, including his allocation to U.S. government bonds or large-cap stocks. Chances are the actively-managed government bond fund and large-cap stock fund will lag the market, hurting his overall return. Consequently, even if the investor finds a market-beating emerging markets stock fund, this outperformance will be at least partially neutralized by the other market-lagging funds.

Core ETF and Satellite “Other Stuff”

A better strategy is a “core and satellite” approach. For efficient asset classes, invest in low-cost ETFs. Limit your investments in actively-managed funds to those operating in less efficient asset classes.  Even in these less-efficient asset classes, you could invest some in ETFs just in case you make a mistake in selecting your actively-managed fund.

According to BlackRock’s (NYSE: BLK) iShares division, a typical core/satellite structure has 70% of the total investment portfolio in core ETFs, leaving the remaining 30% available for alpha-seeking investments. The 30% can be invested in actively-managed funds or in specialized ETFs (e.g., single-country or industry sector) that one thinks will outperform the overall market.

Portable Alpha

Another strategy for combining ETFs with alpha seeking is to buy an actively-managed fund and short the relevant ETF against it.  This “pairs trade” attempts to isolate alpha while eliminating the beta risk of the asset class. This strategy is also called “portable alpha.” Theoretically, a bond investor that doesn’t want to assume the risk of emerging market stocks could still benefit from a skilled emerging markets stock manager by purchasing her actively-managed fund and shorting an emerging markets ETF — like Vanguard Emerging Markets ETF (NYSE: VWO) — against it.

Tax Loss Harvesting

ETFs can also help an active investor with taxes. Even the best investors make mistakes and have trading losses. Near the end of the calendar year, it is a good idea to sell your losing trades and use the capital losses to lower the tax due on the capital gains of your sold winning trades. Often the losing stock is still a good long-term investment, so a popular strategy is to double down on the stock and then sell half in order to maintain your exposure and reap the capital loss at the same time.

However, the IRS has a “wash sale” rule that disallows losses if you buy back what you sold within less than 31 days. Consequently, the last day to double down and still be able to sell a losing investment before the end of the calendar year is November 30th. 

By doubling down with a specialized ETF in the same industry sector as your stock, you can avoid the wash sale rule and still wait until the very end of December to double down and sell. For example, if you want to harvest tax losses in a tech stock you own, you could buy an equal dollar amount of the SPDR Technology ETF (NYSE: XLK) and then sell your tech stock near the end of December 2011. Then in February 2012 you could sell the XLK and buy back the tech stock.

Note: I am not a tax expert, but I like to play one on TV.

Caveat Emptor

Of course, alpha seeking may backfire and result in negative alpha (underperforming the benchmark indices). That’s the challenge of chasing the dream if you choose to accept it. That’s why adding a core slug of ETFs to your portfolio can help contain the damage if you guess wrong on your satellite funds.

Invest in the Best ETFs With the Help of Global ETF Profits

To find the best ETFs, I suggest checking out Ben Shepherd’s Global ETF Profits investment service. Ben is an expert at ferreting out the lowest-cost ETFs for your core portfolio, as well as isolating those specialized ETFs to overweight in your satellite portfolio for maximum alpha.

Give Global ETF Profits a try today!