Core-satellite investing is a method of portfolio construction designed to minimize costs, tax liability and volatility while providing an opportunity to outperform the broad stock market as a whole. The core of the portfolio consists of passive investments that track major market indices, such as the Standard and Poor's 500 Index (S&P 500). Additional positions, known as satellites, are added to the portfolio in the form of actively managed investments. Read on to find out how this works.

Portfolio Construction
First, look at the core portion of your portfolio. The assets will be allocated to investments that are designed to be managed passively. For example, you could put half of the assets dedicated to stocks into an index fund that tracks the S&P 500.

For the actively managed portion, the goal is to select investments where a portfolio manager's skill provides an opportunity to earn greater returns than those generated by the passive portion of the portfolio. In this example, you could put 10% of the portfolio into a high-yield bond fund and divide the remaining stock portion evenly between a biotechnology fund and a commodities fund. The asset allocation might break down as shown in Figure 1 below.

Investment Percentage
S&P 500 Index Fund 50%
Actively Managed High-Yield Bond Fund 10%
Actively Managed Biotechnology Fund 20%
Actively Managed Commodities Fund 20%
Figure 1

Keep in mind that this portfolio is simply an example. The core portion of the portfolio can be used to track any index, including those that intentionally reflect a style bias for value over growth, growth over value, government bonds over corporate bonds, domestic markets over foreign markets or whatever you prefer. Similarly, the sky is the limit in the satellite portion.

The Essence of the Strategy
Regardless of the specific investments chosen to fulfill the asset allocation - cost, portfolio volatility and investment returns are the underlying considerations. A brief review of each area provides additional insight:

The core portion of the portfolio helps to minimize costs because passive investments are almost always less expensive than their active counterparts. Because passive investments track indices, the portfolio changes only when the index changes. Because indices change infrequently, transaction costs and capital gains tax are minimized. Active portfolio management, on the other hand, is based on trading. Each trade generates execution costs and potential tax liabilities in the form of capital gains.

Beta is a measure of stock market volatility. Volatility is something many investors prefer to avoid. By dedicating a large portion of a portfolio to passive investments, the beta of the total portfolio should not come in high. Adding investments, such as a commodities fund, which are not correlated to the movements of the stock market as a whole, helps limit overall volatility when the markets are in flux.

Active managers seek to outperform their benchmarks. By allocating a minority of the portfolio to active management, the opportunity is in place for an active manager to outperform the benchmark, thus adding to the return generated by the overall portfolio and resulting in benchmark-beating returns for the portfolio as a whole.

Implementation Strategies
A core-satellite portfolio can be implemented in a myriad of ways. An mutual fund portfolio, as shown in Figure 1, is just one potential implementation. This strategy can also be implemented using various combinations of separately managed accounts, exchange traded funds (ETFs), mutual funds, stocks, bonds and any other combination of core index-tracking investments coupled with alpha-seeking investments.

The Bottom Line
The core-satellite approach provides an opportunity to access the best of all worlds. Better-than-average performance, limited volatility and cost control all come together in a flexible package that can be designed specifically to cater to your needs.

Related Articles
  1. Mutual Funds & ETFs

    Top ETFs For Investing in Greece

    Find out if it's time to add the GREK ETF -- the only major Greece-centric exchange-traded fund in the world -- as a risk/reward play to your portfolio.
  2. Personal Finance

    A Career In Real Estate Portfolio Management

    Find out why this job more closely resembles the role of a CEO than an asset manager.
  3. Investing Basics

    Portfolio Management Pays Off In A Tough Market

    A clear rebalancing strategy is a critical component of portfolio management, particularly in tough economic times.
  4. Investing Basics

    Portfolio Management For The Under-30 Crowd

    Young investors have some advantages over their older counterparts. Read on to learn how to build a portfolio that will grow with you.
  5. Retirement

    Portfolio Management Tips For Young Investors

    Discover how to start building a portfolio and how to manage it for the best results.
  6. Professionals

    The Workings Of Equity Portfolio Management

    Achieve analytical efficiency by applying your evaluation to a key set of stocks.
  7. Mutual Funds & ETFs

    4 Mutual Funds Warren Buffet Would Buy

    Learn about four mutual funds Warren Buffett would invest and recommend to his trustee, and discover detailed analysis of these mutual funds.
  8. Mutual Funds & ETFs

    Passively Managed Vs. Actively Managed Mutual Funds: Which is Better?

    Learn about the differences between actively and passively managed mutual funds, and for which types of investors each management style is best suited.
  9. Investing Basics

    3 Alternative Investments the Ultra-Rich Usually Own

    Learn about the ultra rich and what normally comprises their net worth; understand the top three alternative investments usually owned by the ultra rich.
  10. Stock Analysis

    The 5 Best Dividend Stocks in the Healthcare Sector

    Learn about the top five dividend stocks of companies operating in the health care sector that generate substantial cash flows to afford high payouts.
  1. Can mutual funds only hold stocks?

    There are some types of mutual funds, called stock funds or equity funds, which hold only stocks. However, there are a number ... Read Full Answer >>
  2. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  3. Do mutual funds pay interest?

    Some mutual funds pay interest, though it depends on the types of assets held in the funds' portfolios. Specifically, bond ... Read Full Answer >>
  4. Do prepayments provide working capital?

    Prepayments, or prepaid expenses, are typically included in the current assets on a company's balance sheet, as they represent ... Read Full Answer >>
  5. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  6. Do mutual funds pay dividends?

    Depending on the specific assets in its portfolio, a mutual fund may generate income for shareholders in the form of capital ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  2. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  3. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  5. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  6. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!