The core-satellite approach to investing

October 2016

Find a balance of active and passive investments to achieve good returns.

There’s a reason this is one of the most popular styles of managing a portfolio, writes Eva Diaz.

Investors usually focus on what they should invest in – shares, property, fixed income – rather than how they should invest.

But this is the wrong way to approach investing. Rather than assembling a random assortment of shares and other assets, investors are often best served by following an investment method, where each investment forms a logical part of a total investment portfolio.

The core-satellite method of organising an investment portfolio is about finding a balance of active (satellite) and passive (core) investments to achieve good returns for the investor.

Active investing means choosing individual stocks or securities, or managers who will do this for you, in the hope you will outperform the market. These investments usually have higher fees and higher risk. Active investments include assets whose price or value can fluctuate over a period of time. This means investors need to watch the movement in value of these assets. Shares or equities are the most common example of active investments.

Passive investing involves investing in a strategy that tracks a market-weighted index or portfolio. These investments usually have lower fees and lower manager risk, because the manager isn’t choosing individual stocks. Passive investments include assets with a fairly stable or constant price and value. Index funds and index ETFs are considered passive investments as these investments broadly track an underlying market index, delivering close to market returns.

Strengthen the core, set up satellites

The core-satellite approach is widely-used and popular. The passive “core” portion (e.g. 60 per cent to 70 per cent) is often invested in a managed fund that reflects the value of a section of the sharemarket (such as the biggest 200 companies), while the remainder “satellite” (e.g. 30 per cent to 40 per cent) is actively managed by the investor, or an appointed active fund manager.

While there is no magic formula in deciding what percentage of a portfolio should be allocated to the “core” or “satellite”, advisers work with investors to find the best solution for them.

How passive or active assets are allocated will depend on how actively an investor would like to manage their investment portfolio. What is most important is to make sure the core and satellite investments work together.

“The idea behind the core-and-satellite investment approach is that the components must complement each other. The ‘satellite’ investments should enhance the return as well as the risk/return profile of the overall portfolio,” ANZ ETFS Management business development manager Kanish Chugh says.

Core-satellite investing can be thought of having two distinct parts: one for long-term strategic investments and another for short-term investments. For example, an investor who wants to save up for a comfortable retirement may set aside 70 per cent of their total investment money in passive assets in managed funds. This portion of the investment will stay in place and will not be withdrawn even if there are short-term fluctuations in the value of the fund because it is specifically allocated for the long-term.

The other 30 per cent of their investment money can be allocated to stocks that may deliver value for a short period of time. For example, buying some retail stocks and selling them when they grow in value may deliver short-term gain and boost the overall portfolio. Retail stocks are considered “cyclical” investments as their price may fluctuate depending on the economic environment. Investments in cyclical stocks needs more active management than passive investments.

“The core-satellite approach is an effective way of investing in a combination of long-term ‘buy-and-hold’ assets and short-term actively managed ones. By implementing this asset mix investors can capture long-term growth and at the same time have the flexibility to take advantage of short-term opportunities as markets move,” Chugh says.

Finding balance, achieving return

Whether you’re just starting to build your investment portfolio or you already have a well-established portfolio that you’re seeking to grow, the core and satellite approach is a suitable and well-founded methodology to grow your wealth.

Some investors may choose to have only blue-chip equities (such as the 100 biggest companies on the stock exchange) as the core of their portfolio, invested through an index fund, as they are regarded as being more stable that other stocks and return money (dividends) frequently. Such an investment ensures investors earn an ongoing income while holding quality assets for the long-term. (In Australia, many investors, particularly those nearing retirement, choose to invest in large-cap stocks for their dividend income.)

The satellite component of a portfolio can be made up of small-cap stocks or particular sectors that deliver short-term and above-market returns. But to get the most out of these sectors, these investments must be watched carefully and actively managed.

One of the most significant aspects of the core-satellite approach is that investors can tailor it to their own level of comfort.

Savvy, market-aware investors may want a significant portion of active investments that they monitor and adjust and talk to their adviser about frequently. Others may prefer to allocate more funds to investments that don’t require interference but they feel confident can generate returns. This flexibility of the core-satellite approach is one reason it has become so popular.