The Fix The Investments Series
Anyone who’s ever exercised knows that having a strong, solid core has become the benchmark for overall fitness. This applies to your investments as well.
Core-satellite investing may sound esoteric or somewhat space agey, but it’s really a very simple approach to strategically allocating your portfolio assets, and one of the brilliant ways to manage your Exchange Traded Fund portfolio. If you are already an ETF fan, then you’re no stranger to things like minimizing fees and costs, reduced tax liability, and managing risk and volatility. How does it work?
The Core
The “core” in the core-satellite portfolio will typically be a dominant position in an ETF that represents a major index comprised of the largest stocks measured by their capitalization. Some of the most widely used are SPDR S&P 500 ETF (SPY), iShares core S&P 500 ETF (IVV), Vanguard Total Stock Market ETF (VTI), Vanguard S&P 500 ETF (VOO), and iShares MSCI EAFE ETF (EFA).
These are all very large, heavily traded Exchange Traded Funds that represent the dominant market share in the ETF space. One of these will be the foundation, or core, of your portfolio. You may decide that these large cap funds should occupy a range of 40% to 60% of your total portfolio, based on your objectives-based goals. This single ETF will likely remain a relatively fixed position for a long time. Why? Because the big, old, good companies that make up the dominant indexes are large caps.
They add stability to a portfolio and their returns are a bit more predictable over time than their, small-cap, mid-cap counterparts. And relative to the rest of the market, they also tend to have a high yield, that is, pay cash dividends. Your core positions are big and generate dividends but it’s generally harder to squeeze excess alpha out of them. In other words, these big underlying companies are more stable and predictable, they are generally considered value stocks, thus it’s much harder for active managers to add value by getting extra returns beyond the index.
Have you noticed that except for a handful of actively managed large cap mutual funds, most of these large caps revert to the mean? That is, they all do about the same as their underlying benchmark index, in other words, they do what the market does, less actually due to loads and fees. High fees and poor management, can’t keep up with the Dow-Joneses or the S&P 500 performance wise. And because of those excessive loads and fees, most have fallen far behind.
…core positions are big and generate dividends
but it’s generally harder to squeeze excess alpha out of them…
So for the core position, a large cap, passive ETF that tracks the large indices like the S&P 500, are there to add stability and long term performance in the large cap sub-asset class space that managers can’t seem to beat.
To recap, because it is very difficult to seek excess alpha in the large cap space, your core must be a cheap proxy for the large cap market. An Exchange Traded Fund.
The Satellites
Orbiting around the core are the“satellites.”
They can be passive or active (we prefer passive, but not opposed to some limited positions where opportunistic investing may be exploited for investors still in their accumulation phase) and generally represent those asset sub-classes where management may add excess alpha.
While there are too few of them, this is how the great managers earn their keep, by generating alpha, positive returns above the benchmark indices they manage against.
For instance, if the Russell Microcap index returns 8%, but a manger through her skill can add excess return, or alpha, that bumps the return to 12%, then she has earned her paycheck. (The Russell Microcap Index is a capitalization-weighted index that captures the smallest companies in the Russell 2000, plus 1,000 smaller U.S.-based listed stocks.)
In many core-satellite portfolios, the satellites are actively managed, while others construct the entire portfolio using Exchange Traded Funds or no-load index mutual funds. Long term investors should focus on their many other important personal financial objectives rather than become absorbed solely by investment concerns, so a passive approach will be best when seeking to attain their long term goals.
Followers of our blog and clients understand that we also feel there are times one can be more opportunistic, and still stay well within the confines of our passive approach. A skilled manager, with a LONG track record at outperforming their benchmarks in a NICHE market is worth consideration for those willing to accept the added risk in hopes of outperformance, and only then in accordance with a fully developed objectives-based plan. Thats a lot of caveats but, hey, this is your money were talking about!
Core-Satellite is one form of strategic asset allocation, which first depends on fully understanding the overall goals of the investor.
Market performance is market performance. While there are skilled managers who have beaten their benchmarks, many more have fallen behind, so for most investors who don’t want to “fund-hop” year to year, causing even further damage to long-term returns, a low cost, passive “be the market” strategy is generally be best.
Can I do this myself?
Absolutely.
We advise against it.
We advise against it because asset allocation is an ongoing discipline, not a one-and-done exercise. The upfront research and selection process takes many factors into account when selecting classes, sub-asset classes and alternative choices, and finally, the ETFs or index funds that will fill the class allocations must be chosen from a field of contenders. The weighting that each fund will represent in a portfolio is an exercise in risk management, not a lust for outsized returns. Going forward, there must be a defined process not only to monitor the portfolio, but rebalance the allocation when normal allocation targets change through price movement.
Core-Satellite is one form of strategic asset allocation, which first depends on fully understanding the overall goals of the investor. For instance, the allocation of asset classes and sub-asset classes will be vastly different for a millenial and a retiree, or different for each member of those generations, based on individual preferences.
The table below is NOT a recommendation. It merely shows one example of how a core-satellite portfolio may be constructed from asset sub-classes.
Investment |
% |
|
Large Cap ETF – S&P 500 |
50% |
|
Mid Cap ETF or Index Fund |
10% |
|
Small Cap ETF or Index Fund |
10% |
|
International ETF or Index Fund |
10% |
|
Specialty ETF, Index or Actively Managed Index Fund (Tech, Biotech, Energy, Banks, etc) |
5% |
|
Specialty ETF, Index or Actively Managed Index Fund (commodities, metals, real estate, etc) |
5% |
|
Cash |
10% |
Why Core Satellite?
Portfolio construction and strategic asset allocation are not new ideas. They are time tested approaches to investing as a discipline, as opposed to a random series of baseless decisions. The paramount objective is to invest according to your goals, never try to outguess, outsmart or beat the market, and commit to invest for the long term, that is, stay invested in all types of markets, up, down or sideways.
Risk management is first and foremost, so a method to measure it and track it is paramount. Will it be an income generating portfolio or is the goal purely long-term growth? Tax efficiency, time horizon and estate considerations will also come into play as the maps are being drawn. Managing risks (market, financial, time, industry, etc), managing costs (commissions, fund loads and internal fees), and managing taxes (short versus long term gains, ordinary income, tax efficiency through asset location) all take a front seat to returns, because each of those disciplines offers a “hidden alpha,” not often considered by novice investors.
As such, the discipline involved over time to stay invested in all types of markets, up, down or sideways, is a paramount objective.
Like any investment methodology, Core-Satellite is not a one-size-fits-all approach, but it is certainly a time-proven method to strategically allocate and manage assets, and one more way you can be the market.
Read Also: Strategic Asset Allocation. BE the market.