Explaining a ‘core-satellite’ approach to investing

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CMC Invest

18 April 2023

Key points

  • A “core-satellite” strategy combines a passive portfolio with the active trading of assets.
  • The majority of assets in a “core-satellite” strategy are held in passive, broad-based investment products. A smaller slice of the portfolio is then used for active trading.
  • Having a larger “satellite” portion of your portfolio does come with greater risk, but also gives you the ability to generate higher returns if you’re able to pick stocks that perform well.

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When you invest, your capital is at risk.

Important: This article is for general guidance purposes only and should not be considered investment advice. If you are unsure about the suitability of an investment, please seek out advice. When you invest, your capital is at risk.

Many long-term investors are content to simply follow a passive investing strategy. Some, however, want to build a portfolio for the long term while also taking advantage of shorter-term opportunities they see in the market.

From the title of this article, you’ve probably guessed that the latter strategy is often referred to as taking a “core-satellite” approach. The idea is to increase returns by seeking out individual stocks to trade while allocating the majority of the portfolio to a low-cost passive strategy. Let’s dig a little deeper to understand this strategy…

"You’re trying to achieve returns in excess of the market by actively trading in selected stocks."

What is the core-satellite approach to investing?

In this strategy, the majority of the work is being done by the “core” of your portfolio. It’s the unchanging passive part that you hope to rely on for standard returns. In addition to this, you’re trying to achieve returns in excess of the market by actively trading in selected stocks.

Let’s imagine that every day you wear the same clothes. Grey trousers, grey t-shirt and a grey sweater. For the most part, these work well for you. They keep you warm; they’re functional and comfortable. You don’t necessarily need to change anything about your outfit.

One day, however, the weather forecast suggests there’s a 50% chance of snow. You look outside and decide it’s worth opting for something a little bit extra. You don a bright yellow hat. There’s every chance you’ll look foolish if the wintery weather doesn’t materialise. If it does, however, you’ll be warmer than usual.

This is kind of how a core-satellite approach to investing works. Your everyday apparel is like the passive part of your portfolio, while the garish hat is an active choice that may or may not pay off.

The core

When investors adopt this approach to investing, the “core” portion of the portfolio may be made up of ETFs tracking major stock indices or replicating broad bond markets. Think products that replicate the FTSE 100 or S&P 500 for stocks, or those investing in high-quality corporate issuances for bonds.

The idea is that these funds are held for the long term so that they generate returns representative of broader markets. While there is no hard and fast rule about exactly what proportion of assets should be held in the core part of your portfolio, it’s often suggested between 60% and 80% of your assets are utilised for this part of the strategy.

The satellite

The “satellite” portion is the part of the portfolio you actively trade in. The goal is to pick assets which can generate higher returns on their own.

You may, for example, choose to buy a stock because you believe it’s going to benefit from a cyclical trend. An example would be e-commerce companies during the early days of the Covid-19 pandemic and national lockdown measures.

Investors also tend to utilise more focused ETFs for their satellite strategies. You could, for instance, decide to purchase an ETF localised on a particular country if you have a strong belief in the economic prospects of that nation. Or, alternatively, you could opt for a fund concentrating on a specific industry if you think it is set up to benefit from market conditions.

Why do people adopt a core-satellite approach?

A core-satellite approach can be framed as something of a middle-ground between actively trading stocks and passively holding on to investments for the long term.

The appeal lies in being able to realise market returns while having some flexibility to take more risks – in the hope of generating higher returns – by trading actively in stocks you have a strong conviction for.

If your stock picks underperform, you still have the core part of your portfolio to fall back on. Of course, there is never a guarantee that either part of your portfolio will generate gains.

You can also use a more conservative core – say one which is invested in assets like investment-grade bonds – to offset taking more risks with the satellite portion of the portfolio.

Are there drawbacks to this approach?

While the goal is to create additional returns, there are no guarantees that the satellite portion will perform better than the core. It may do worse if your stock picks don’t perform the way you anticipated.

It’s important, therefore, that you thoroughly research the assets you’re planning on trading within this part of your portfolio. You also need to stay abreast of market trends and news and react accordingly with your trades.

If you don’t have the time – or the knowledge – to research into individual assets, then you may wish to opt for an entirely passive approach to investing. Warren Buffett is even a fan of this for investors who can’t dedicate much time to research.

Getting started with a core-satellite strategy

As something of a recap, here’s some considerations you’ll need to take before implementing a core-satellite strategy:

1. Decide on a ratio between the two portions of your portfolio

What portion of your portfolio do you want to use to discretionally trade? This may depend on what your ultimate goals are.

If you’re simply trying to generate a little bit of extra return, you may only allocate 20% (or less) of your portfolio as available to utilise for satellite positions. If your risk tolerance is higher and you’ve plenty of time to do your own research, you may be trading with as much as 40% of your portfolio.

2. Decide on your core asset allocation

What assets will represent the core part of your portfolio? This will be influenced by a number of factors, such as your overall risk tolerance.

How would you feel about this part of your portfolio falling in value suddenly? If you’re a long-term investor and this doesn’t make you shudder, then you may consider investing most of your core portfolio in stocks. If, on the other hand, a sudden drop in your portfolio value makes you anxious, you may wish to include lower-risk assets, like bonds.

Additionally, will you have time to make up losses from your portfolio, before the need to generate a return as you work towards your financial goals? If time is more limited, you may again want to invest more conservatively.

3. Decide on satellite allocation

Satellite allocations may change frequently depending on what you want to invest in at given times. It’s entirely possible you don’t see opportunities to buy individual assets, instead choosing to grow the size of your core allocation.

There’s a higher concentrated risk when investing in individual stocks – or even narrowly focused fund products – than broad index-tracking funds. A higher satellite allocation, therefore, will often carry more risk but could potentially bring higher returns with your own thorough research.

To summarise, a core-satellite approach is one many investors opt for when they want to enhance market returns with an active trading strategy. To be successful, the “satellite” part of the portfolio has to generate excess returns, which means trading at the right time. That requires research and discipline and the ability to stay on top of market events.