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Does core-satellite investing still stack up?

Apr 07, 2020

The ETF Securities Partner Series joins with Australian and international investment professionals to discuss the big issues of the day and what these mean for investors. Periods of market volatility often mean investors question the construction of their portfolios. Using a core-satellite investment approach has traditionally been valuable in periods like this, as it gives the ability to pivot satellite investments to manage market activity. The theory might be sound, but is it holding up to the COVID-19 test? ETF Securities spoke to Jonathan Ramsay, Director of InvestSense on the topic ‘Does core-satellite investing still stack up?’ What is core-satellite investing? Core-satellite investing is a two-pronged approach to portfolio construction, where the core is made up of broad passive exposures to major asset classes (mainly equities and fixed income) and the satellite investments are more opportunistic and designed to seek specific growth outcomes, sometimes at higher levels of risk. These might typically be actively managed funds, but could also be investments in individual companies, real estate or one of a growing number of more-targeted ETFs. Generally, the core might be 65-85% of the portfolio, depending on the investor’s goals, investment horizon and risk tolerance, while satellites tend to represent 15-35% [1]. What a core-satellite portfolio looks like will vary depending on the investor’s needs. “We’ve got one [portfolio] which has an emphasis on cost, and it uses a lot of ETFs to keep the costs down… we’ll add some of the traditional satellite active managers alongside that. We’ve got another couple with more of a high net worth focus. And there, they might have a very active core,” says Mr Ramsay. In the same way, one product might sit in the core for a particular investor but be treated as a satellite investment for another. Gold is an example of this. Mr Ramsay says, “we had it as a kind of core alternative, if you like… We’ve had other clients who’ve also wanted to increase their defensiveness…who have used it as more of a proactive thing.” The theory behind the practice Core-satellite portfolio construction and its enhanced version are based on modern views of efficient market theory. Efficient market theory assumes that companies are correctly priced based on all known information at all times, which means that it’s not possible to consistently outperform the market using fundamental research . Research indicates efficient market theory is true to an extent - the true value of investments does typically win out in the long term – but it’s still possible to find short term patterns and opportunities to help generate higher returns [2]. In the COVID-19 situation, the theory would suggest that it is possible to use the market fluctuations to protect or grow your portfolio. Mr Ramsay is putting the theory to the test, with some of his clients particularly focused on accessing the disruption. “They want to make changes quite often quite quickly. And especially in this kind of environment,” says Mr Ramsay. Active v passive The original view of core-satellite investing considers the core as purely passive, with satellites tending to be active. While many investors still use it in this way, given the cost efficiencies of having a passive core, some investors these days have reversed this approach. “There’s an ability to use an active core or a passive core, depending on the particular investor,” says Mr Ramsay. He doesn’t hold a preference for either style, seeing a use for both, but suggests that many investors may wish they’d used a passive core for the cost efficiencies down the track. For those investors with an active core, Mr Ramsay has found passive investments like ETFs valuable as satellites, particularly in these times. “These kinds of clients… have been transacting a lot more quickly and reacting to market environments and using ETFs for that purpose…For instance…rotating into Asia, out of Europe, out of the US is what happens at the moment,” he says. ETFs have also been useful during this period because their pricing closely matches the market at any given point in the day, compared to other unit trust products where you might not know what price you’ll get until the end of the day. Mr Ramsay explains, “your reason for making a shift can change radically during the day. So you might start off the day thinking… this market looks cheap, or we want to go more defensive or whatever it is.” From this perspective, using ETFs may better allow you to express your view on market activity at a particular point of time, responding to scenarios as they occur rather than waiting for them to play out. This makes them a natural fit for satellites, as well as for core investments. Performing into the future Fortuitously, Mr Ramsay had positioned his clients defensively before the COVID-19 situation became a concern, viewing markets as expensive. “Sometimes expensive markets are like a bug looking for a windshield,” he said, noting that initially this positioning dragged on performance but, “in this, you know we’ll probably have done 25% better than our market composite.” He remains a proponent for core-satellite investing as the structure has allowed him to move rapidly and flexibly for his clients. Does core-satellite investing stack up at the end of the day? Only time will really give investors the performance-based answer to this question. Since we don’t have a crystal ball, the facts are simply that core-satellite investing is a responsive and flexible approach where investors can adjust to changing markets while still holding a core portfolio targeting long term goals. From that perspective, core-satellite investing continues to stack up. [1] [2] Malkiel, Burton G. The efficient market hypothesis and its critics, Journal of Economic Perspectives, Vol 17, No 1, Winter 2003, pages 59-82.

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COVID-19: Where are we now? Where are we going?

Apr 01, 2020

The ETF Securities Partner Series joins with Australian and international investment professionals to discuss the big issues of the day and what these mean for investors. COVID-19 has dominated headlines for months and is influencing rapid change in the way we live and work. Change at any time can be unsettling, but combined with a serious health threat, it can drive anxiety and concern not just on a social level, but also in financial terms. ETF Securities spoke to Jon Reilly CIMA, Chief Investment Officer for Implemented Portfolios and Adam Dawes, Senior Investment Adviser for Shaw and Partners on the topic ‘Where are we now? Where are we going?’. The state of the nation for financial markets “We’re in the middle of a deliberate demand shock. We’ve chosen for very good reasons to shut down our economies, and it’s going to be a hugely dislocated, disruptive event, we know that.” Says Mr Reilly. While markets rebounded slightly this week on the news of positive manufacturing numbers in March from China, it’s fair to assume the volatility is not over and recovery may be some time away. “It’s been a very stressful time for all of us in the financial markets and certainly, going forward, I think it’s not going to get any easier,” says Mr Dawes. If we look at China as an example across the peak of the crisis, the economic data was worse than many analysts had anticipated. Across January and February 2020, Chinese industrial production fell 13.5%, service production fell 13%, retail sales fell 23% and exports fell 17% [1]. Even assuming China is able to move back into full scale production rapidly, it is trying to recover in a world where other countries are moving into full scale lockdown and we are yet to see what the lockdown has meant in terms of income shock to individuals and businesses alike in China [2]. Alongside China, US markets continue to dominate the global economy so consideration of their ability to recover also needs to be factored. There are questions around its ability to contain the pandemic or whether economic and political measures from the government and the Federal Reserve will offer enough of a buffer to prevent a recession. In the wake of the US death toll now exceeding official Chinese numbers, US President Trump is anticipated to release a fourth wave of stimulus focusing on infrastructure (a policy from his 2016 campaign) [3]. Australia has taken a number of measures to manage the current situation. The Reserve Bank of Australia reduced the official cash rate to 0.25% and announced a program of quantitative easing – a significant announcement given it was not a measure used even in the heights of the Global Financial Crisis [4]. The Federal Government has also announced a number of stimulus measures to support businesses and individuals – with some predicting more announcements to come [5]. Uncertainty plays into investor psychology and it’s been hard to find pockets of safety in the volatility. “There was nowhere to hide, whether it was Aussie equities versus international equities. Bonds got sold off significantly as well. That was disconcerting for people in the early days. It’s been pleasing to see some sense of order returning to those markets” says Mr Reilly. A greater market correction than expected While no one could have anticipated the COVID-19 pandemic and the influence it would have on market volatility, both Mr Reilly and Mr Dawes suggest that a market correction (to an extent) had been overdue anyway. “I certainly feel that markets were overvalued… we had some conception that markets were a little bit toppy” says Mr Dawes. Mr Dawes has found specific assets and sectors have offered defensive positioning. “Consumer staples has been a fantastic spot. We were overweight in that sector and we didn’t do a lot of selling of Coles, in fact, we added to it even if clients did have Woolworths in their portfolio. Two years ago, we put 5% of gold in everybody’s portfolio and … it has held up really, really well for us”, says Mr Dawes. In this environment, it has been valuable to focus on fundamental beliefs and research for investments. “When we look at what we put into a client’s portfolio and what we don’t, we look at how much income will they get, how quickly are earnings going to grow, and what’s the valuation price? What’s someone going to pay for your investment in the future?” says Mr Reilly. Where are we going? Both suggest there may be opportunities from the current environment but caution that a slow and steady approach is beneficial to managing potential ongoing volatility. “We’ve made a first step in to buy a little bit more Aussie equities, a little bit more A-REITs. We’re still taking a long-term view. We think there’s absolutely some generational buying opportunities here” says Mr Reilly. Mr Dawes adds, “You don't need to be a hero, you just need to buy quality and good quality companies with good balance sheets and just absolute quality, top 50, top 100, top 200. Even if you wanted to go with some of the ETFs, ZYAU is a very good one also because it provides a good dividend.” ETFs across the COVID-19 pandemic As with the rest of the market, ETFs have not been immune to the volatility, particularly bond ETFs, but they continue to offer a responsive way for people to adapt to these changing markets. “ETFs, as a whole, have really made this market today what it is. The ability now for me to go into gold, to go into the US, to go into far-reaching parts of the world on the ASX and be able to buy that and be able to put a portfolio together. The diversification that I’ve got in my clients’ portfolios now is far greater than it was 10 years ago,” says Mr Dawes. ETFs traditionally offer a cost-effective way to instantly deliver broad, diversified exposure. This characteristic may be useful in the current market volatility to allow investor to tilt in favour of defensive or growth investments. Mr Reilly suggests this, along with liquidity, may even drive new converts to ETFs after this crisis. Even so, investors should refer to the basics of investing and the fundamentals of the companies, sectors and countries they want to invest in. “ETFs are a wonderful portfolio tool, but it doesn't preclude you from doing the work to understand what you own in this very convenient wrapper of an ETF structure.” says Mr Reilly. Finishing on a note of optimism It’s worth remembering that, as with most things in life, the COVID-19 situation will not last forever and this too shall pass. Being measured and taking a long-term approach can assist in managing the volatility and in positioning you well for the eventual recovery.

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