Q39: What is Core/Satellite Investing?

A solid base with added managed risk can help to enhance portfolio returns.

Investing in the financial markets requires a thoughtful strategy that balances risk and return. Core/satellite investing is an approach that combines the stability of index funds as the core with the potential for active funds to enhance portfolio returns. This article explores the concept of core/satellite investing, highlighting the role of diversification in managing risk and the potential benefits of incorporating active funds as satellites.

The Concept

Core/satellite investing is a portfolio construction approach that combines passive and active investment strategies. Readers of TMQ will be familiar with index funds which form the core component of the portfolio. These funds aim to replicate the performance of a broad market index such as the S&P/ASX 200. Index funds offer diversification, low costs and a systematic approach to investing. They provide investors with exposure to a wide range of companies within a specific market segment or asset class.

The satellite component comprises actively managed funds, which are carefully selected by fund managers who aim to outperform the market. Active funds allow for more flexibility and the potential to exploit market inefficiencies through active stock selection, market timing, and asset allocation decisions. They also allow the addition of some specialised or more speculative investments to a portfolio. Not everyone wants to follow an index-only strategy (even though it’s argued that this is the most appropriate way to go for most investors). By incorporating active funds as satellites, investors seek to enhance portfolio returns beyond what the core index funds alone can offer.

The Core

The core of a core/satellite portfolio is built on index funds. Index funds offer several advantages that make them an ideal foundation for long-term investors. Firstly, they provide broad market exposure, spreading investments across numerous securities, which helps reduce the effect of individual stock volatility on the overall portfolio. Diversification aids in managing risk, as losses in one holding can be offset by gains in others. The way you choose to blend these funds depends on your risk and return objectives but, whatever the mix, the allocations in the core portfolio should stay reasonably static over time.

Index funds typically have lower fees compared to actively managed funds. The lower costs translate into more money in your pocket, making index funds an attractive choice for the core portion of the portfolio. Additionally, index funds are inherently more tax-efficient than their actively managed counterparts due to their low turnover and focus on long-term investing.

The Satellites

The satellite component of a core/satellite portfolio comprises actively managed funds that complement the core holdings. Active funds offer the potential for skilled fund managers to capitalise on market opportunities, make tactical asset allocation decisions, and select individual securities that may outperform the market.

The inclusion of active funds as satellites provides the opportunity to achieve additional returns beyond what the index funds in the core can deliver. Skilled fund managers can utilise their expertise, research capabilities, and insights to identify undervalued securities, emerging trends, or market inefficiencies. Through active management, these funds aim to generate alpha, which is the fancy term for the return above the benchmark index.

The satellites can include investments of a more speculative nature such as single stocks, or investments in alternative assets like emerging markets shares, actively-managed bonds, fine art, classic cars or any other investment class. The important part is that these satellite investments are smaller in value and may be more likely to change over time.

It’s always important to note that active funds come with higher fees and the risk of underperformance compared to their benchmark indices. Careful due diligence is necessary when selecting active funds, considering factors such as the fund manager’s track record, investment philosophy, and consistency of performance.

The diagram below shows an example core/satellite investment allocation. The main investment — and the one that stays central to the portfolio — is the diversified core of index funds. Around that lie the active or speculative satellite allocations. These vary in their proportion of the overall portfolio and may change quickly as market opportunities arise. What investors should bear in mind is how the core and satellites work together. It’s the whole-of-portfolio approach that is important: the satellites should work to enhance the core.

Conclusion

Core/satellite investing offers investors a balanced approach that combines the stability and low costs of index funds with the potential for active funds to enhance portfolio returns. By using index funds as the core, investors gain broad market exposure, diversification and long-term cost savings. The addition of actively managed funds as satellites allows for the potential capture of additional returns through skilled stock selection and market timing. They can also allow an investor to take a small speculative position in the markets, if that type of excitement is what they’re after.

Diversification plays a vital role in managing risk within a core/satellite portfolio. By spreading investments across different asset classes, sectors and investment styles, investors can smooth the effects of individual security or market segment volatility. The core/satellite approach recognises that both passive and active strategies have their merits and by combining them effectively investors can seek to achieve a well-rounded portfolio that balances risk and return.

The success of a core/satellite strategy relies heavily on careful selection of both the index funds for the core and the active funds for the satellites. Thorough research, due diligence and understanding of fund manager strategies and performance are crucial to ensure the chosen active funds have the potential to add value to the overall portfolio.

Core/satellite investing offers a balanced and diversified approach to portfolio construction. The core, consisting of index funds, provides stability, broad market exposure, and low costs. The satellites, comprising actively managed funds, aim to enhance portfolio returns by capturing the expertise of skilled fund managers. By combining these components effectively, investors can potentially achieve a well-rounded portfolio that manages risk through diversification while seeking opportunities for additional returns through active management.