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How to build a portfolio with core and satellite funds

17 November 2023

Wealth managers discuss the merits and shortcomings of the strategy.

By Jean-Baptiste Andrieux,

Reporter, Trustnet

Many investors use the core-satellite investment strategy to build their portfolio. This approach consists of allocating the bulk of your money in a small number of key funds (or potentially just one) alongside smaller positions in funds that can generate alpha via niche areas or shorter-term assets.

While this strategy may be simplistic in theory, wealth managers say there is a lot of merit in the approach. One of the benefits is the ability to diversify a portfolio and enhance returns while lowering volatility.

Meera Heardon, investment director at Parmenion, said: “By balancing investment styles and strategies, an investor is utilising greater flexibility. Importantly, it can also remove the inconsistent nature of trying to time markets and back high quality managers that can all deliver solid returns at different times of the market cycle.”

Another benefit of the core-satellite strategy is that it should ideally prevent investors fiddling too frequently with their portfolio as the core element should be focused on long-term investment. 

Ryan Hughes, investments director at AJ Bell, added: “By operating such an approach, investors should be able to avoid over-trading, instead leaving the core element to compound over the long term.”

As the core element of this strategy is likely to be made of passive funds, this approach also enables investors to keep overall portfolios costs low, with only the satellite holdings attracting higher fees.

The downside of this approach is that the satellite components may not generate the levels of desired alpha, or worse, generate loses. This, in turn, can lead to an overall underperforming portfolio as the core elements may not be able to make up for the losses caused by the satellite funds.



How to build the core part?

The core part should invest in more mature companies and industries, providing the portfolio with a ballast. It can be made of a few funds or just one.

A typical core fund would be either a passive or a broadly diversified and style-agnostic active fund, which seeks to generate a smaller level of alpha over long periods of time.

Kamal Warraich, head of equity fund research, Canaccord Genuity Wealth Management stressed, however, that the latter category is a dying breed due to the shift to passive investments, which has “inadvertently caused most ‘core active funds’ to be viewed as closet trackers”, noting that those that do exist tend to underperform due to their higher fees.

For those who use passives as their core index funds, Warraich said they should look at the tracking error, replication methodology and all-in costs before buying their units.

For those using active funds, Heardon noted that they should “demonstrate characteristics of strong steady long-term returns as well offer better capital protection in difficult market conditions”.


How to choose your satellites?

The definition of a satellite is broad but generally refers to a more volatile and higher risk fund. That could mean investing in less efficient parts of the market, such as emerging markets or smaller companies, focusing on specific sectors, such as healthcare or technology, or a specific style bias.

There are also two ways of using satellite funds, either strategically or tactically. The strategic approach implies that the investor will stick for the long-term with a potentially high alpha generator, while a tactical approach is more short-term in nature and seeks catalysts for alpha.

Warraich explained: “For example, a certain style may be out of favour (e.g. value has sold off), but you wouldn’t change your core in response to this. You could, however, include some value funds in your satellite allocation to potentially make a decent return in a short space of time.“  

As for how many satellites an investor can hold in a portfolio, there is no golden number. For Warraich, it depends on the number of opportunities an investor has identified.

He said: “If you have identified two, three or four ideas then you can go for it – it really depends on what you consider to be the opportunity set, your timeframe and your risk tolerance, as well as how those opportunities blend together from a risk/reward perspective.”

Hughes was more precise, suggesting that each satellite holding should account for at least 3% of the portfolio so it can genuinely add value. But as satellites are likely to carry more risk, an individual position should not exceed 10% of the portfolio.


How should you split the allocation?

There is no fixed allocation an investor should strive for when it comes to balancing core and satellite holdings but, in general, the core part should make up the larger part of the portfolio.

Warraich suggested to allocate 60% to 70% to the core with the difference in satellite funds, whereas Hughes preferred an even higher emphasis on the core part.

He said: “For many investors around 75% allocation to the core elements of the portfolio could be worth considering, as this will be the main determinant of the long-term returns.

“If this can be left to work over the long-term, then the focus can be on the remaining 25% in satellite positions which shouldn’t then dominate the portfolio.”

He also warned that investors must figure out how involved in the management of their portfolio they want to be, as satellite funds may require closer attention as they tend to be in more niche areas. Therefore, the more satellite funds an investor holds, the more time an investor will have to spend monitoring their portfolio.

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