To the clients and friends of ProfitScore:

In the previous month, we explored the consequences of passive indexing on correlations. This month, we shift our lens to optimizing correlations within portfolios. As finding uncorrelated asset classes becomes increasingly complex, we’ll delve into the merits of the core-satellite strategy.

A strategy that has gained traction, especially among institutional investors, is risk budgeting. Here, capital is allocated based on associated risks rather than merely anticipated returns. For most retail investment accounts, such risk budgeting often goes overlooked.

Refer to Image 1 below, where we’ve calculated the downside deviations for exchange-traded funds: SPY60% results in 6.45%, and AGG40% yields 1.35%. A 60/40 portfolio split between 60% SPY and 40% AGG registers at 7.20%.

Image 1

Interestingly, even when equities comprise only 60% of the allocation, they contribute to a staggering 90% of the portfolio’s risk. This underlines the complexities surrounding risk distribution. As we further our discussion on correlations and introduce risk budgeting, it becomes clear that a need for nuanced risk management strategies looms on the horizon.
This is where integrating alternatives or adopting a satellite strategy proves crucial. By aiming for returns that aren’t purely tethered to market beta, investors can inch closer to achieving their correlation objectives. This approach becomes a vital tool for risk reduction, especially during tumultuous market times. In essence, diversifying return avenues can act as a buffer against market fluctuations, paving the way for more consistent portfolio results.
Now, envision a departure from the conventional 60/40 allocation. What if we employed a core-satellite strategy, allocating 50% to SPY, 30% to AGG, and 20% to a satellite like the ProfitScore Regime Adaptive Equity Index Image 2 illuminates the potential of the core-satellite approach to dampen risk, especially when juxtaposed against the traditional 60/40 portfolio.

Image 2

This illustration underscores the advantage of integrating satellites or alternatives to bolster portfolio diversification. As the renowned economist Harry Markowitz, recipient of the Nobel Prize, once remarked, “Diversification is the only free lunch” in the investment realm. Diversification remains central to the triumph of Modern Portfolio Theory. It begs the question: how would your portfolio fare during the market’s most challenging times when correlations across most assets spike to 1?

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