Core-Satellite Investment Strategy
The core-satellite strategy is a way of incorporating actively managed funds and other investments into your portfolio while reducing risk and costs.
Core/Satellite investing describes a situation wherethe largest proportion of the fund is invested in such a way as to generatemarket returns. This component of the fund is referred to as the "Core Component", and will generally involve the use of index managers or assets which make up a particular index.
In order to potentially increase the overall fund return, a core/satellite approach to investing will also include the use of actively managed assets - through an active manager, or purchased directly. This actively managed component will generallybe much smaller in size than the Core component.
This strategy appeals to investors who are attracted to the distinct philosophies of active managers, or those who like to invest directly in shares themselves, but prefer a lower risk strategy. It works just as well in diversified investment strategies as it does in single sector ones.
You start with a core of single sector or diversified index funds. You then add individual shares or actively managed funds (the satellites) commensurate with the level of risk and diversification you want to achieve.
Many financial advisers use a diversified index fund to achieve their client's asset allocation and add a combination of lowly correlated active funds as the satellites.
Using low-cost index funds as the core strategy can be one way to implement your asset allocation and reduce your overall costs of investing.
Any managed portfolio has two ways of providing investors with returns above the risk-free rate. The first is by taking on systematic risk factors that are rewarded (so called normal returns due to the “betas” of the portfolio); the second is by creating performance over and above the fair remuneration for the risks taken by the manager. Such abnormal return (“alpha”) is necessarily due to the skill (or luck) the manager has in selecting securities or shifting his exposure between risk factors over time.
Traditional active asset management, as practiced by a majority of mutual fund managers, does not favour a clear distinction between beta management and alpha management. On the other hand, most active managers, because they face tight tracking error constraints, are mostly passive. Such an approach may be costly and inefficient, but it also leads to confusion for the investor, since the latter is exposed to a large number of implicit decisions the fund manager takes. Some stock picking decisions, for example, may actually lead to a risk factor exposure for the portfolio that is not coherent with the initial asset allocation decision of the fund.
A paradigm change is taking place in asset management with the core-satellite approach, which advocates a clear separation of a passively managed core portfolio from one or more very actively managed satellites. In terms of tracking error management, the core portfolio closely replicates the benchmark, so that the tracking error comes from the tracking error of the satellite portfolio. Investors may therefore turn to very active satellites and still assure an overall tracking error that is relatively low, because the satellite has a low weight in the overall portfolio. Separating alpha and beta management by using a core-satellite approach allows for
i) a better distinction between good and poor performers
ii) manager diversification in the satellite portfolio
iii) greater transparency and cost-efficiency
In order to understand core/satellite investing, it is important to first understand the difference between index (passive) investment management and activeinvestment management.
Index (passive)investment managers invest their respective portfolios with a view to generating a return that tracks a specificindex. For example,many of the Australian share index fundstrack the ASX 200or ASX 300 Index. These indexes plot the daily combined movement in the top 200 and 300 stocks listed on the Australian Stock Exchange (ASX). Whilst we have used the ASX 200 & ASX 300 in our example, there are many other indexes which plot the movement of listed share prices. There is also a large number of international equity indexes, as well as indexes that measure the movements in bonds, property, cash, etc.
Some of the characteristics of a fund which aims togenerate index returnsare;
- returns are likely to be very close to the return of a specific target index
- investment management fees will generallybelower than the fees charged by active managers
- the turnover of the fund will generally be lowerthan the turnover of an actively managed fund - which may reduce anycapital gains tax on realised gains.
- theunderlying assets of the fund and the decisions to buy or sell those assets is managed in the main by a computer, ie there is little human intervention in the stock selection process.
Active investment managers invest their respective portfolio with the objective to outperform a target benchmark - typically, an index of some sort (ASX 200, ASX 300, MSCI, etc). For example, an active manager may describe the objective of their fund is to outperform theASX 200. In this example, the managers of the fund would be stating to prospective investors that this is the objective of the fund -to outperform the ASX 200.
Some of the characteristics of an actively managedfund are;
- investment management fees tend to behigher than the fees charged by active managers
- the turnover of the fund tends to be higher when compared with the turnover of active managers - which may lead to greatercapital gains tax/losses on realised gains/losses.
- the underlying assets of the fund and the decisions to buy or sell those assets is determined by a team of investment managers.
Fundamentally, active managers are of the view that they can generate above market (index) returns through superior stock selection.
Why mix index and active managers?
By mixing index managers with active managers, the potential outcome may be enhanced. Put another way, a core/satellite approach may increase the market return - through the use of professional investment managers.