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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% .
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 .
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.
 Malkiel, Burton G. The efficient market hypothesis and its critics, Journal of Economic Perspectives, Vol 17, No 1, Winter 2003, pages 59-82.