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A core and satellite asset allocation strategy is one of the most popular ways to invest. But does it still make sense when markets are falling?
Core and satellite typically involves investing the bulk of a self-managed super fund’s resources in investment funds that track the market. Then, a smaller portion of the assets are allocated to investments that deliver specific exposure, which reflects the investor’s view of the world.
A balance between passive and active investment strategies is at the heart of most core and satellite strategies, notes Michael Miller, a certified financial planner with Wealth Market Northbourne.
“It can still be a sensible approach simply because it provides a blend of the two styles. The more volatile markets of recent times are yet to prove conclusively that one approach is better than the other, so using both can give some balance,” explains Miller.
While core and satellite is a strategy advisers often recommend for retail investors and SMSFs, it’s also used at an institutional level.
“You’ll often find a core and satellite approach if you look under the bonnet of many multi-manager diversified portfolios,” he adds.
We asked advisers about whether core and satellite is still appropriate given current market conditions.
The case for…
Integral Private Wealth principal adviser and director Luke Ranson believes a core and satellite investment strategy is still relevant in today’s market.
“The core delivers the beta a client needs to provide a market return with diversification across a variety of asset classes. The satellite provides some flexibility and an opportunity to capture market alpha. Allocating your capital across different funds in a core and satellite approach also provides some extra liquidity and control,” says Ranson.
Beta is the return the market delivers, while alpha refers to any additional return on top of the market’s performance.
Ranson says a core and satellite strategy can also have lower management fees and be more tax-efficient than having all your capital invested in an actively managed fund. For example, let’s say you have five per cent of your portfolio in an active fund and swap active managers. It’s entirely possible the transaction costs and potential capital gains tax would be much lower than if a larger proportion of your portfolio were actively managed.
Ideally, Ranson says your core portfolio should capture the major movements of the wider market. While your satellite component gives you the opportunity to capture opportunities in different companies or industries.
Let’s say you want 70 per cent of your portfolio to be invested in a diversified exposure to global equities. With a core and satellite portfolio, you could allocate 50 per cent of your SMSF to one low-cost equity ETF, which represents the core. Then, 20 per cent of the portfolio could be apportioned across four actively managed funds, representing the satellite part of the fund. The other 30 per cent of your fund could be allocated across low-cost cash and fixed income funds.
Ranson suggests asset allocation is arguably more important than timing the market or stock picking, so it’s important to get it right. “For the satellite component of your portfolio, in particular, make sure you do your research to find a fund manager who has a strong track record, extensive experience and knowledge.”
The case against…
One adviser who is not a fan of core and satellite is AJ Financial Planning founder Alex Jamieson.
“The traditional approach of applying an index fund manager as a core and coupling this with growth or value managers as the satellite is doomed to fail. This is because most satellite managers are overpaid index funds providing little in the way of outperformance,” says Jamieson.
“There is opportunity within this investment strategy but it requires a different approach. It involves taking satellite exposure via a specific asset classes index fund or using stock-specific positions,” he adds.
An example of this would be using an index ETF that delivers exposure to the ASX 200 index as the core. The satellite provides specific exposure, for instance ETFs focused on technology stocks or the pharmaceutical sector or gold miners.
Says Jamieson: “The underlying idea is to tap into longer-term thematic trends, which should have natural tailwinds into the future. This approach also assists in avoiding overexposure to failing shares or companies that have a poor outlook included in an ETF that tracks the index. Remember, an index holds both the very best companies as well as ones that may be almost bankrupt.”
Another strategy is to use a more unusual broad market ETF as the core and direct share exposure as your satellite exposure. Jamieson says investors might get their core allocation through Van Eck’s MOAT ETF, which is designed to give investors exposure to US businesses the fund manager perceives to have a competitive advantage in their sectors. This would be complemented by a tactical satellite exposure with direct shares positions such in companies such as hearing aid leader Cochlear, toll road provider Transurban and artificial intelligence and machine learning firm Appen.
“This targets specific individual investment options in areas which should perform well into the future and have reasonable valuations against to fair value calculations.”
He says this approach can provide a level of outperformance over the medium to longer term when appropriately linked to the correct investor risk profile and investment objectives.
“When it comes to investing, our underlying belief is an asset manager is no different from playing sport. Most people can bounce a basketball but few can replicate the success and skill of Lebron James. Investing is no different,” adds Jamieson.
Miller says it’s important to be mindful of the costs of maintaining a core and satellite strategy. “You need to regularly review your investment managers. Changing your managers is likely to lead to transaction costs in swapping managers, even on the parts of the portfolio that are common across managers.”
“A multi-manager diversified portfolio that uses investment mandates will avoid those transaction costs. Regularly reviewing managers at a portfolio level may achieve some cost savings. This can be the best option for smaller portfolios, especially if the costs of individual management outweigh any benefits gained.”