The core-satellite approach to building an investment portfolio can help reduce portfolio risk while still giving investors an opportunity to outperform the market. The core-satellite strategy also has benefits in terms of low-costs due to trading commissions, passive investing, and capital gain tax deferrals.
My personal investment portfolio follows a core-satellite approach so that if I have a bad year in my “satellite” positions, my spouse cannot get too upset with me as the “core” part of our investment portfolio has supported overall returns and our retirement plans remain secure!
This article will discuss the logic, benefits and construction of a portfolio which follows the core-satellite approach while I continue to share pieces of my own personal application of the portfolio strategy for some real-life perspective and fun.
The “Core” Brings Stability
The stability that is gained from the application of a core-satellite portfolio is brought about by the “core”, which represents low-cost passively managed holdings such as an ETF that tracks the S&P 500.
The core ideally should embody the benchmark of the portfolio which portfolio returns will be judged against. As the core’s systemic risk resembles the overall market, it reduces the risk and volatility of the portfolio as it will track returns of the benchmark.
As the core holdings are passively managed, investors will also benefit from low-costs both through avoiding trade commissions and also the fact that passive funds carry cheaper management expense ratios. Through the core, there is also the benefit of reduced tax expenses, as passively managed holdings will not be frequently bought and sold, incurring capital gains tax which lower the compounding effect of returns.
Author’s Application: The core of my portfolio is built up by low-cost ETFs which make up around 25% of my portfolio’s weight. Also considered core holdings for my portfolio are Canadian bank stocks (which is my home country). Similar to the ETFs, these bank investments are held passively, I only add to them in order to keep them approximately equally weighted, and I do not plan to sell them before retirement. I also do not hold ETFs which track the smaller Canadian market specifically so these Canadian bank weightings are my main ongoing exposure to my home country, which is part of my portfolio’s benchmark.
As these passive ETFs will not be sold for years (if not decades), they are held outside of my registered accounts to save my registered account contribution room for investments that will be actively traded and would otherwise incur frequent capital gains tax. The Canadian banks are held within registered accounts to keep their large dividends compounding tax-free!
Add “Satellite” Investments to Achieve Alpha
Once the core of the portfolio is established, one can start to add smaller “satellite” positions in an attempt to generate market beating returns and alpha. As these satellite positions are actively managed investments which will make the portfolio’s weight deviate from the benchmark, they will add not only add return potential but also additional risk and volatility to the portfolio.
Satellite positions do not necessarily have to be specific company stocks or bonds but they could also be more expensive actively managed mutual funds or other exotic investments. In either case, the satellite positions are being made in an attempt to achieve alpha and try to beat the benchmark return.
When investors are considering adding satellite positions to their portfolio, they should remember to do their homework, stay within their circle of competence, and only make high-conviction investments. Many satellite positions an investor might consider are probably already represented in the passive core index holdings, and making that specific company investment will be overweighting the stock relative to the passive benchmark.
Remember that the core is already diversifying the portfolio and investors do not need to substitute core passive holdings for satellite positions just for the sake of diversification. This can result in a “diworsification” effect that reduces the overall risk-return characteristics of the portfolio. Keep satellite positions high conviction!
Author’s Application: As a personal risk management rule, each specific satellite position generally cannot exceed a 2.5% weight of the portfolio, but this weighting can be exceeded with verbal consent from my wife after I make my investment thesis and valuation in our own personal investment committee and get her approval!
I keep track of my portfolio’s weighting by sector and geography so that I am aware of the exposure relative to my benchmark but I am not troubled if my satellite positions take me far away from the benchmark weighting. I use my satellite positions to gain exposure to companies and industries I see as being undervalued, regardless of the diversification effects.
The “Core” Weighting can be Adjusted
The core-satellite strategy is a great portfolio construction strategy for beginner investors and experts alike, as the core part of the portfolio is passive and its weight can be adjusted based on the skills and performance of the investor and the availability of alpha-generating opportunities in the current market environment.
For beginner investors, the passive core part of the portfolio might represent 100% of the portfolio to begin with and then slowly be reduced over time as the investor builds their experience and skill-set. Track your portfolio’s returns relative to your benchmark in order to gain an understanding if your satellite positions are attributing to market beating returns.
Author’s Application: The core of my portfolio once represented over a 50% weighting but after years of steadily beating my benchmark returns I have gotten permission from my spouse to take this core passive weighting down to 25%. This percent weighting of the core jumps around quarter to quarter as if I am unable to find any new strong conviction satellite positions, the proceeds from selling satellite positions which have realized their potential could be reinvested in the core.
Takeaway for Investors
The core-satellite approach to portfolio construction is a great strategy to keep costs low and gain stability in investment results. The strategy’s core acts as a stabilizer that keeps the portfolio diversified, while satellite positions give investors the opportunity to stray away from their benchmark and pursue high-conviction investments in an attempt to create market beating returns.
Remember to stay within your circle of competence when it comes to satellite positions and not overly diversify for the sake of it!