The Fix The Investments Series

Core-Satellite. Core and Explore. A rose by any other name…

Often called Core and Explore, the basic portfolio construct is to have a CORE position in large cap value and growth stock indices (say, the S&P 500 Index for strictly domestic or MSCI World for International developed markets, including the US), and have SATELLITE positions (small- and medium-cap stocks, as well as emerging markets, fixed income and alternative positions) as dictated by your desired objectives-based allocation plan, orbiting the core. 

Having a core position in low-cost, efficient big cap index funds or Exchange Traded Funds, is based on the premise that it has proven to be near impossible for managers to consistently eke out extra alpha, or excess return, above the index performance it manages against. 

The foundation of your portfolio is the core position, a cheap ETF that tracks a major index that maintains a relatively constant weighting in the portfolio, in other words, a 40% stake remains a 40% stake, give or take a percentage point or two, which will rely on periodic monitoring and rebalancing.

…the foundation of your portfolio is the core position,

a cheap ETF that tracks a major index …

But it’s the satellite segments of your portfolio that might lure you into a “Beat The Market” state of mind. How?

We know that large cap managers have a hard time generating excess alpha in their space because the large cap stocks are so efficient, meaning they trade at higher volume at prices that more closely reflect the underlying company. Add to that, the large cap market is more liquid, has far more research coverage, financials are more reliable and available. That’s a tough environment for alpha hounds!

But in other subclasses–small-cap, mid-cap and emerging market s, for instance–active managers can navigate their holdings to outperform the market because those spaces are less efficient than the large cap space and more ripe for outperformance due to the inefficiencies in their spaces. But do they actually outperform?

Reams of research suggests that the vast majority of active managers, regardless of the cap space in which they operate, rarely or never consistently outperform the indices they manage against. Sure, they have their moments, but do you know when those moments are about to begin? Or end? No, we don’t either. So, naturally we are led back to the path of intelligent investing, by using low cost, passive ETFs for our satellite positions.

The benefits of an ETF-based core-satellite portfolio include:

Choice. The vast universe of ETFs available today ensure that you can occupy any and all asset classes that your allocation dictates, no matter how traditional or cutting-edge.

Cost. Passive approaches are cheap. Active Management costs more money. Often, a lot more. That money (loads, commissions and trading costs) erodes your returns, which research has often shown can be less than the indices in the first place.

Performance. You will NEVER underperform the market by bad security selection or manager selection. When you decide to “be the market,” rather than beat the market, your overall returns improve. Underperformance is not an option!

Let’s be honest.

Let’s be honest. Wall Street firms and their brokers are still clinging to their active management model. They have to. Underwriting and issuing stock is their bread and butter, and those newly issued securities have to come off the shelf and find themselves a good home in a managed account or mutual fund. Plus, actively managed accounts charges higher fees because it appears to be, well, active. “See, we are doing something to earn our 3% a year!” And they stand to lose billions of dollars in revenue if they switch to passive management. It’s really that simple.

While many independent advisors, financial planners and money coaches preach the benefits of going passive, the big houses on Wall Street can never fully embrace a passive approach. It would harm every line of business they’re in, from underwriting and dealing to retail brokerage. In recent years, Wall Street has been dragged kicking and screaming into a fiduciary world where the rules are different, tighter and fairer to the clients. Instead of basing their future revenue on your naivete, maybe they should try using passive approaches to make you money, and save their active strategies to help you keep what you make.

The bottom line: A passive approach remains a superior approach for investors, and one that makes Wall Street nervous.

Work Your Core. And Satellites.