Constructing Absolute Return Funds with ETFs

Abstract

This article develops an application of ETFs to the management of an absolute return fund. The use of dynamic core-satellite portfolio management makes it possible to construct absolute return funds using ETFs on stock and bond indices. As a result of the ease with which they are traded, ETFs make an ideal vehicle for putting dynamic risk budgeting into practice. The advantage of the dynamic core-satellite portfolio is that, unlike conventional strategic or tactical asset allocation, it relies solely on the observable price path of different ETFs, and a range of predefined parameters. So the problems of estimation and prediction uncertainty of the two conventional allocation methods are avoided. The combination of advanced dynamic risk-budgeting techniques and highly liquid and transparent instruments may provide a more investor-friendly way to deliver a given absolute return with a target level of volatility, independent of prevailing market conditions.