If you’ve read about core and satellite investing, then you may have some familiarity with this well-known approach: The core holding of your portfolio is a big, cheap ETF that tracks a large-cap index like the S&P 500 or MSCI, and the more specialized satellites orbit the large-cap core, which are typically small- and mid-cap, international, and specialty sector holdings.
Core-satellite investors are interested in asset allocation, and may employ some form of tactical allocation in their strategy. Some of these same investors will use this approach as a foundation for tilting. What does tilting mean?
Tilting generally means over-weighting the portfolio with some favored investment sector that differs from your allocation model’s stated percentage. For instance, if your model calls for 50% equity, and you are at 54%, you are tilted, or overweight in equities, by four percentage points. If you are following a level-line allocation plan, you would capture those four percentage points of profit and use the cash to shore up a lagging asset class, say bonds or real estate.
Some of the most popular factor tilts for ETF investors who employ a core-satellite approach are: over-weighting by cap size, by investment style, by industry, by sector, and by region.
You start by establishing your standard diversified core equity position, say the S&P 500, by using the Strive Asset Management S&P 500 ETF (STRV), for example.
Your research has led you to believe that financials, or maybe energy, may be industries that should outperform the general market over the next market cycle or cycles. So, you might add a few shares of the financial and energy ETFs as satellites, to overweight the existing financial and energy positions already captured in your existing S&P 500 position.
..Tilting generally means over-weighting the portfolio with some favored investment sector..
You would tilt your portfolio in this manner if you have a reasonable belief or expectation of getting a higher return than the general market, in other words, alpha. But understand this: while returns may be enhanced, so is the risk. Alpha has a cost.
There is ample research on this subject, the most notable being the value and small-cap studies on tilting by Nobel Laureates Eugene Fama from the University of Chicago Booth School of Business, and Kenneth French, from Dartmouth College.
Their Three-Factor Model explains the risk and return profiles of equity portfolios across three dimensions: market risk, size risk and value risk. While there are almost unlimited ways to overweight or tilt a portfolio using these and other style factors, their studies focused on value and small cap stocks.
But don’t mistake this for market timing. You are not attempting to beat the market, per se. The greater complexity of tilting is an attempt to amp up the returns of your portfolio, and though the overall portfolio risk rises in proportion to the percentage that you overweight, it can still be considered a valid passive management approach in its own right. You may call it “passive plus,” but tilting requires research and demands caution.
…while return may be enhanced, so is the risk…
While there are those times when it may make sense to overweight given sectors of the economy, your hunches and your research, just like everyone else’s hunches and research, can prove to be wrong. There is a cost to tilting if you make the wrong moves, which is why a straightforward passive allocation approach will satisfy most investors who seek to build long-term wealth without having to outguess the market, or even more difficult, outguessing small pieces of the market.
There are no rules, of course, to how much percentage wise makes sense for a tilt, but 1% to 5% in a tilt is probably the most aggressive you would want to go if you are an otherwise committed passive investor.
Total market index ETFs will give you whatever the broad market delivers, up, down or sideways, but if you are determined to try to enhance your alpha, going for a little extra return from a favored sector or industry or region, you can tilt by using the most relevant ETF.
There are no rules, of course, to how much percentage wise makes sense for a tilt, but 1% to 5% in a tilt is probably the most aggressive you would want to go if you are an otherwise committed passive investor. Total market index ETFs, like SPY or IVV, will give you whatever the broad market delivers, up, down or sideways, but if you are determined to try to enhance your alpha, going for a little extra return from a favored sector or industry or region, you can tilt by using the most relevant ETF.
You will have your pick: in 2021 there were over 8,500 exchange traded funds to choose from!
Remember, too, that passive ETFs are “tracking stocks.” They represent their underlying index in a pure form, and so their returns will almost exactly reflect that of the underlying index,minus its small internal fee. Managed ETFs will often stray from the underlying index. Why? Because they tilt in a very tactical way.
Any changes or enhancements to that almost perfect tracking will be out of whack. Adding an additional 5% weighting to any of the ten S&P sectors, for instance, and you will experience tracking error, either up or down.
…a portfolio that is tilted in the wrong direction can be underwater for a long time…
There is no right answer to how much you should tilt your portfolio, or if you should do it at all. But the more you tilt, you are getting very close to simply making a bet. There is a downside: if you are wrong it can cost you a lot of time and expense to get back to your original wealth creation targets.
A portfolio that is tilted in the wrong direction can be underwater for a long time, and if that turns out to be the case, you will be more likely to behave badly, and we know that bad investor behavior kills returns and subsequent wealth building efforts.
Tilting is not a short-term deal. It’s not about flavor of the month. It may be a very intelligent way to enhance portfolio returns in an otherwise long-term passive approach. Higher returns sound great, until you realize that higher risks come right along with them, so discipline and patience are key to the strategy.
There is a commitment that goes with this style of investing, and poor or untimely choices may force some investors out of the position long before its had the chance to do what they wanted it to do, namely, enhance their portfolio returns.
The last thing you want to hear back from a bruised portfolio is “Tilt!”