Core-satellite investing: a prudent approach for the long term

EVERY so often certain investment themes catch your eye, such as clean energy, artificial intelligence or climate change, where the investment propositions sound intriguing and potentially very rewarding.

But how much should you allocate into more narrowly focused themes? How do you go about selecting themes to invest in that enable you to have your cake and eat it - that is, reap higher returns and still sleep well at night?

The most sensible route is to take a core-satellite approach to your total portfolio. Core-satellite investing is a standard approach among institutions such as pension funds for a number of good reasons. Its benefits are particularly resonant for individual investors whose need to stay invested for the long term is often challenged not only by market volatility but also by whims and emotions.

As the term suggests, core-satellite investing breaks your overall portfolio into two components. The core component typically comprises broadly diversified holdings representing your strategic asset allocation for the long term. If you are in your 30s, for instance, and investing for retirement, your investment horizon may be as long as 30 or 40 years. Your core allocation may be a 70/30 mix of global equities and bonds. To harness the power of compounding for the long term, you commit to regular investments, and may review and adjust your asset mix as you approach retirement.

The satellite component comprises investments into a specific market, sector or theme, and as such would merit a smaller allocation relative to your core holding. This is because satellite investments are typically higher risk; a technology fund, for example, may be very concentrated with only 40 or 50 holdings.

Endowus recently launched six satellite portfolios to complement its core offerings. For the core allocation, investors may choose between Flagship and ESG (environmental, social and governance) portfolios. There are six variations of asset allocation ranging from 100 per cent equity to 100 per cent bonds.

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The satellite portfolios are exposures most frequently requested by clients: technology; real estate; megatrends; China fixed income; China equities; and low-volatility fixed income. Each portfolio may be likened to a multi-manager fund of funds. This ensures that even in the satellite allocation, investors will be well diversified. Of course, you also have the flexibility to pick individual funds as a satellite holding through the firm's Fund Smart platform.

For either core or satellite portfolios, Endowus seeks to lower the cost of investing by making available the institutional share class of funds where annual management fees are substantially lower than retail share classes. If the institutional share class is not available, it rebates all trail fees which are the share of annual management fees paid to distributors.

But first, here are some reasons why a core-satellite approach is sensible and prudent. One, this approach reflects the evidence based on research that asset allocation is key to long-term returns. Vanguard says in its advisory on core-satellite investing: "Market timing and security selection may provide some short-term gains at times. However, over the long term, research studies have proven that asset allocation is far more important." It cites research by Brinson, Hood and Beebower which conclude that asset allocation accounts for 94 per cent of the variation in portfolio returns, and market timing and security selection make up the balance of 6 per cent.

Two, a core holding of passive asset allocation funds enables investors to invest efficiently: They reap the "beta" or market returns at lower cost. This gets into the perennial debate of active vs passive funds. Long-term performance data shows that most active managers fail to beat indexes consistently. But a judicious combination of passive and active allocations through core-satellite investing can get investors ahead.

The alpha or value-add above the market is expected to come from the satellite allocation, for which you pay higher fees for active management.

In an article, S&P Dow Jones Indicies head of South Asia Koel Ghosh wrote: "Asset allocation models are critical to achieving a portfolio's investment objective. Beyond asset class diversification, a combination of strategies can prove beneficial. This is where the core and satellite strategy assists in effective portfolio construction. A strong core provides stability and can contribute to risk mitigation and, ultimately, reaching the financial objective of the portfolio."

Indexing, she wrote, offers the benefits of diversification, lower costs, transparency, lack of fund manager bias, among others. "An active strategy as a satellite can selectively explore the inefficiencies in the market and scope undervalued market opportunities toward the achievement of the overall portfolio objective."

Twin benefits

Morningstar portfolio strategist Amy Arnott says a core-satellite approach offers twin benefits of risk mitigation and lower costs. "The basic idea is that with the core, which could be 80 to 90 per cent of your portfolio, you focus on low-cost, passively managed index funds that can give you exposure to major asset classes. The satellite would be a smaller percentage, maybe 10 to 20 per cent, which could consist of actively managed funds or more specialised asset classes...

"It could be an investment theme that you are especially interested in and believe has a lot of potential for the long term. Or, if you worry about inflation becoming a long-term issue, you could allocate some funds into asset classes like gold or commodities."

Endowus chairman and chief investment officer Samuel Rhee says core portfolios should form the backbone of any investor's overall strategy. "For many clients, while the satellite portfolios may look enticing, they may not need to look beyond the core portfolios for building long-term wealth and reaching their investment goal."

He warns against portfolios whose underlying funds all belong to the satellite allocation. "It is interesting to note that many digital wealth platforms, including several robo advisers, are actually using a satellite portfolio as their core strategy with active asset allocation or heavy overweights in certain countries or sectors. In addition, others often compound initial satellite portfolios with even more satellite portfolios, thereby creating a satellite-satellite portfolio instead of a core-satellite portfolio."