A Guide To Core/Satellite Investing

by Lisa Smith (Contact Author | Biography)

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Filed Under: Bonds, ETFs, Financial Theory, Forwards

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 indexes, such as the Standard and Poor's 500 Index (S&P 500), the Russell 3000 Index, the Lehman Aggregate Bond Index and the JPMorgan Government Bond Index. 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, determine your asset allocation. Perhaps you are a balanced investor, allocating 50% of your portfolio to stocks and 50% to bonds. Next, look at the core portion of your portfolio. These assets will be allocated to investments that are designed to capture the average returns generated by a specific market. In a taxable portfolio, you will want to choose indexes that don't change very often to minimize tax liabilities. (For related reading, see Asset Allocation Strategies and Five Things To Know About Asset Allocation.)

Looking at the core portion of this sample portfolio, you could put half of the assets dedicated to stocks into an index fund that tracks the S&P 500, and three-fourths of the assets dedicated to bonds into an index fund that tracks the Lehman Aggregate Bond Index. (To learn more, read The Lowdown On Index Funds and Don't Judge An Index Fund By Its Cover.)

For the actively managed portion, the goal is to select investments where a portfolio manager's skill provide an opportunity to earn greater returns than those generated by the passive portion of the portfolio. In this example, you could put the remaining portion of the bond allocation into a high-yield bond fund and divide the remaining stock portion evenly between a biotechnology fund and a commodities fund. In a $200,000 portfolio, the asset allocation might break down as shown in Figure 1 and Figure 2 below.

Investment	Amount
S&P 500 Index Fund	$50,000
Lehman Aggregate Bond Fund	$75,000
Actively Managed High-Yield Bond Fund	$25,000
Actively Managed Biotechnology Fund	$25,000
Actively Managed Commodities Fund	$25,000

Figure 1

Figure 2

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.

Costs
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 indexes, the portfolio changes only when the index changes. Because indexes change infrequently, this minimizes transaction costs and capital gains. 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. (For related reading, see A Long-Term Mindset Meets Dreaded Capital-Gains Tax and Seek Out Past Losses To Uncover Future Gains.)

Volatility
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 come in somewhere close to average. 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. (Learn more in Beta: Gauging Price Fluctuations and Beta: Know The Risk.)

Returns
Active managers seek to outperform their benchmarks. By allocating the majority of a portfolio to passive management, the portfolio's risk level remains similar to the risk level of the benchmark. 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 and Figure 2, 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. (Learn how to increase your returns by creating the right balance of risk in Bettering Your Portfolio With Alpha And Beta.)

The Beauty of the Core/Satellite Approach
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.

For further reading, see Achieving Optimal Asset Allocation and Choose Your Own Asset Allocation Adventure.

by Lisa Smith, (Contact Author | Biography)

Filed Under: Bonds, ETFs, Financial Theory, Forwards

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