This Article was originally published in The Global Analyst
Equity investment world is filled with recommendations but sometimes tricky ones. Is this a good time to invest in Pharma stocks? How about ESG? Can Amazon be a good inclusion in the portfolio now since it is nearly 26% down from its peak? Should I sell Nifty futures since I know for sure that markets will tank further? Etc.
Acting upon them can clutter the investment approach as one cannot access and provide for the varying risk/return profile of such diverse recommendations. Mostly, these recommendations are analyzed from a potential return perspective and not so much in terms of what can go wrong. In order to provide some method to this madness, sophisticated investors construct something called “Core/Satellite Portfolio” (CSP). The simple concept is that we keep the unavoidable exposure to the core and avoidable exposure to the satellite part. While the core always remain intact, the satellite options keep changing based on market conditions (also called tactical allocation).
In the core part would be the equity portfolio with defined exposure to large cap, midcap and small cap. The ratio of allocation between these categories is a function of risk appetite. The core exposure can easily be built in a low-cost manner using Exchange Traded Funds (ETF’s) which is like investing in index funds with the additional benefit of ETF’s being more cost effective and liquid as they are traded real time on the stock exchange. Investing in ETF’s can provide market returns while investing with mutual funds can either give more or less returns compared to benchmark based on the effectiveness of the manager. If one wishes to avoid manager risk, then the best low-cost option would be ETF’s.
At this stage, one should determine how much of the total equity portfolio should be in core and how much should be in satellite. Typically, a majority of the allocation (say up to 80%) should be in core and the balance could be in Satellite, again based on risk appetite.
Having determined the allocation to satellite, let us now see the some options available within the Satellite option.
1. Sector Funds: While large cap ETF that forms part of the core is broadly represented by several sectors, satellite can take some pointed bets on a particular sector based on its attractiveness. There are several sector funds that are available today including banking, infrastructure, pharma, technology, etc. One must either be a sector specialist or take advice from advisor on this type of a bet. Sector funds tend to have more volatility than the broad market but they are very popular.
2. Factors: Factor based investing, also called quantitative investing, can be an interesting part of satellite portfolio. Typical strands of factor funds involve value, growth, momentum, etc. However, there are not many funds available in the market relative to other opportunities and hence the choice set is limited.
3. Thematic: Thematic funds focus on a particular theme and position investments accordingly. Typical examples of popular themes include ESG, consumption, dividend yield, energy, Multinational companies (MNC’s), & Public Sector Units (PSU’s). There are funds dedicated to such themes but it would be wise to sift through the stated strategy before committing to such investments. The thematic interpretation can vary from one person to another and hence the problem.
4. International Stocks: For an Indian investor, investing in international stocks cannot be a core component and hence it is recommended to be a part of satellite portfolio. There will not be a dearth of opportunities here especially if it is focused on developed markets like US, Europe and Japan. Again one can take ETF route for this to keep it cost effective.
5. Private Equity: This is an asset class often ignored by retail investors as the threshold limit to invest in private equity is always higher. However, one can focus on listed private equity to get into this interesting opportunity space. While for retail investors, this can be a satellite component, for Institutional investors and high-net worth clients this can be core component.
6. Derivatives: This is the trickiest part as it can range from options to futures to synthetics. If one has a clear forward looking market view (like a bear market), one can do well to sell index futures or buy put options as insurance to core portfolio. However, using derivatives other than portfolio insurance is sure to benefit the brokers than the investors.
Advantages and drawbacks
Having laid out the options, it will be useful to see the merits of following a core/satellite approach to equity investments.
The main benefit of such an approach is that it is an additional source of return (alpha) which investors are always keen on. Assuming that the core portfolio is invested in ETF’s (providing only market returns), it is always good to look for additional sources of return. Also, inclusion of satellite tends to diversify the portfolio and hence the risk. Also, many satellite options laid above enjoy less or negative correlation to the core which adds to the appeal of risk reduction. Since satellite is a tactical positioning, one can quickly change their position based on changing market views.
However, the core/satellite approach also suffers from some de-merits. The main problem with identifying the satellite options is that it is research intensive and therefore time consuming. Almost all satellite options will involve active managers and hence can be expensive. Another troubling issue will be illiquidity with some options like private equity while other options are fairly liquid. Due to these reasons, the core/satellite approach is more suitable for institutional investors and high net worth clients.