There are numerous approaches to investing which each have their own strengths and weaknesses. As an SMSF or individual investor with comparatively small amounts to be invested compared to large industry or retail funds, directly investing in shares or niche funds will involve relatively concentrated investments. This can produce great returns when the selected investments are right, but increases the risk of poor returns due to low levels of diversification.
Investing in a diversified index such a broad based managed fund or exchange traded fund (ETF) may help protect your portfolio from poor performance of a select group of companies or industry but it may also diversify away the benefit of companies or sectors who outperform.
Core-Satellite investing blends these approaches. This allows for you to make your own investment decisions whilst lowering volatility.
How does it work?
The majority of the portfolio can be invested in a core of index funds. The remaining satellite portfolio is invested in high conviction investments.
The core achieves the goals of:
- Reducing volatility across your total portfolio by spreading your risk
- Reducing the ongoing costs of your portfolio
- Reducing the impact of capital gains tax on your portfolio
The Satellite achieves the goal of:
- Contributing your own investment ideas
- Investing in more aggressive assets without risking your entire portfolio
- Possibly outperforming the market
The components of core investments
Core investments should reflect the broader market and asset classes. Index funds such as ETFs are a common way to achieve this. The index can be as wide as a single index with exposure to all global markets or a combination of many different markets.
Indices can offer an inexpensive way to diversify a portfolio. This diversification helps to reduce exposure to specific companies or markets. It also reduces the impact of more volatile satellite investments on your portfolio.
Research in Australia and overseas has concluded that asset allocation is the greatest determinant of portfolio outcomes. The Brinson, Hood and Beebower study, Determinants of Portfolio Performance (1986, 1991), concluded that 94% of the variation in returns was due to asset allocation. Index funds can achieve a broad spread of securities at a low cost.
Examples of satellite investments
Investors can choose from a wide variety of investments to form their satellite component. Some examples of common satellite investment ideas include:
Investing using themes such as the role of technology or the demand for healthcare. These may be very long term strategies. Combining this with the Core-Satellite approach allows you to benefit from the index until the themes delivers.
Small Cap shares:
The volatile nature of small cap companies can have a significant impact on your portfolio if they are successful or otherwise. Using a diversified core can reduce the impact of adverse movements whilst still being exposed to positive movements. To invest in small cap shares you can buy shares directly, utilise ETFs or managed funds.
Individual High Conviction companies:
As an investor you may have a high conviction view of a particular stock that you believe has strong growth characteristics or leads an industry that you believe will be dominant in the future. As a specific company it will only account for a small percentage of the index but you can use the satellite approach to buy shares in the company to increase your total exposure.
Actively managed funds:
Actively managed funds can be costly compared to index funds but they can provide access to complex investments or a particular fund manager’s investment style. Using actively managed funds in combination with an index core allows you to lower the average cost of the portfolio. Actively managed funds can be bought as listed investment companies or ETFs via the ASX, or as unlisted funds. You will typically need to invest directly with the fund manager for unlisted funds.
The Core-satellite approach over the long term
The Core-satellite approach has had varying degrees of success vs. traditional portfolio construction. There is research to suggest it lowers volatility whilst outperforming the market. However, actual benefits will depend on the satellite investments used and the investment period.
Whilst the success of the core-satellite strategy is varied, particularly in the short term, it is clear that there is value in holding the index as a portion of your portfolio. Adding diversification helps reduce volatility and spread the risk from more aggressive investments.
Getting some advice
There is no single formula to determine the weightings for a core satellite portfolio. The satellite portion should vary depending on your risk tolerance and the number of satellite investments you want to have. It is recommended that you seek help from an accredited investment adviser when creating your portfolio. Things to discuss with your adviser would include:
- Overall asset allocation
- Determining portfolio weights between core and satellite. Increasing satellite exposure may increase volatility
- Determining the optimum number of satellite investments
- The actual investments that will make up the core and satellites
CommSec also has tools such as the ETF Screener and Stock Screener available to assist you in finding the right investment for you.