‘Core-Satellite’ Investment Approach
(Originally posted December 13, 2007; re-posted in 2012)
The debate about advantages of active vs. passive investing should be over. The overwhelming evidence suggests that it is extremely difficult to beat the indexes on a sustained basis, especially after management expenses, and it just as difficult to identify a priory who will the one(s) who beat the indexes based on historical performance. The ‘Core-Satellite’ approach seems to be a reasonable compromise for those struggling with the decision of going active or passive in portfolio implementation and those who still believe, and many of us no doubt do at times, that we can ‘add value’ with active management.
‘Core-Satellite’ (or as some call it the ‘Core-and-Explore’) investment approach, widely used by institutional investors, uses an index based passive approach in the ‘core’ to implement the investor’s Strategic Asset Allocation (SAA) and an active approach in the satellite portion of the portfolio. Some individual investor’s portfolios take the same general method. Typically, the core may represent about 80-90% of the total portfolio, though many investment managers, favoring active portfolio management, may suggest ‘core’ proportion as low as 50% (a low ‘core’ allocation may be more justifiable in a very low or negative expected market return environment). The low-cost index/passive implementation in the ‘core’ can also be thought of as the portion of the portfolio that earns the market return for a given level of risk (beta), whereas the active implementation of the ‘satellite’ part of the portfolio can be thought of the part of the portfolio where we are looking to outperform the market and earn excess returns for a given level of risk (alpha).
There are many benefits to using a passive ‘core’ including: low cost and tax efficiency, due to an 5-10x lower management fees than for an actively managed portfolio and lower trading costs and taxes due to lower turnover. Implementing the Strategic Asset Allocation (SAA) in the ‘core’, it is also matched to investor’s risk tolerance, return requirements and reflects long-term capital market expectations, and it provides adequate diversification (downside protection).
The ‘satellite’ portion of the portfolio being active, requiring extra effort tactical asset class allocation or stock selection, will have higher management cost. If the ‘core’ is implemented via classical stock/bond asset allocation, the ‘satellite’ may contain anything from individual stocks or overweighting in some asset classes (as in a Tactical Asset Allocation- TAA) that are already in the ‘core’, to a selection of commodities, real estate, structured products, hedge funds, private equity, derivatives or other asset classes that historically have had low correlations with the ‘core’ assets. The ‘satellite’ can be thought of as being more concentrated (less diversified) and proving upside opportunity.
The use of active portfolio management would make a lot less sense when investing in large companies in efficient markets (U.S. and EAFE) than for small companies, emerging markets, real estate, private equity, hedge funds, etc. These would be naturals for the ‘satellite’ part of the portfolio.
The cost savings of a ‘core-satellite’ approach as compared to applying a 100% active management approach and fees can be readily estimated. Assuming a 2% management fee for active (very low by Canadian and somewhat high by U.S. fund standards) and a 0.2% management fee for index funds/ETFs, would result, for an 80:20 core:satellite mix, in an average cost of 0.56% vs. 2.% for the all active implementation. That is a difficult to overcome 1.44% headwind for the active manager.
One can even think of variations of the implementation, whereby one may use tax losses in the ‘core’ to offset gains in the ‘satellite’ for better tax management of the overall portfolio.
The bottom line is that, if you still interested (believe in) active approach and you have some specific ideas that you want to pursue to secure excess returns at some level of risk (alpha), then perhaps a good way to do it is in the ‘satellite’ part of the ‘core-satellite’ approach and at least you won’t (over)pay for active management fees for the returns offered by the market (beta).