Put your portfolio into orbit

PORTFOLIO POINT: The core and satellite approach offers diversification and a neat balance between active and passive investing, high and low risk.

Core and satellite portfolios offer investors the opportunity to combine the diversification and low cost benefits of indexing with the potential return boosting activity of speculative investing. It provides retail investors with a third answer to the age-old division between passive and active investing.

With the growing popularity of ETFs from Vanguard (click here), State Street Global Advisors’ SPDR (click here) and Blackrock’s iShares (click here) – ASX traded products designed to mirror the performance of an index at minimal cost – this strategy has become much easier and much cheaper to implement (for more on underperforming managed funds that fail to deliver click, see Australia's biggest losers).

The core and satellite approach to investing can be summarised in the below figure. It calls for dividing your portfolio into two parts: the core, which is made up of lower-risk investments that you rely on to cost-effectively achieve your investment goals; and the “satellites” of higher-risk investments, which represent your, or your advisers’ hunches about where excess return can be found.

Building a properly diversified core allows you to be a much more opportunistic risk taker in other parts of your portfolio, which for some is where the fun part of investing lies. If your partner is a lower risk taker than you, then having a resilient core may help them sleep at night or, on a more serious note, manage the portfolio if you’re no longer around.

To build this kind of portfolio and get the potential upside exposure it offers, you need to answer three questions.

• What belongs in the core?
• What are possible satellite investments?
• What should be the relative size of each?

The core investments

The ideal core portfolio includes a number of different investment types including the big three: shares, property and bonds. Your mix of these assets depends on a variety of factors, including your investment goals, your tolerance for risk and your personal investment preferences for assets such as bonds or property.

Burton Malkiel suggested long-term investors should have their age as a percentage in bonds although I would modify this by subtracting 10–20%. Morningstar has summarised a range of asset allocations observed in Defensive to Aggressive portfolios that you may find broadly helpful.

Keep in mind that if your satellite funds are all higher-risk equity-like investments, then your core needs to be more conservative to keep your overall portfolio in balance. Also, if you are fortunate enough to receive indexed income from an employer pension or have a considerable annuity stream you might consider that your core investment.

Your core asset exposures can be assembled in components or through a single multi-sector fund. However, it makes just as much sense to use index funds because they generally deliver a market rate of return at very low cost. Also for taxable investors, their buy-and-hold approach means you get to keep more of your return than share it with the tax office.

While part of your core can be assembled from directly owned Australian shares, I believe you need to invest in at least 20–30 companies, in varying proportions, spread across different industries to fulfill this role properly.

It is often better to get an exposure to Australian shares using an ETF such as Vanguard’s Australian Shares ETF (VAS) or State Street’s S&P/ASX 200 product (STW). Realindex (click here), through a partnership with Colonial, offers low-cost index-like funds where stock composition is weighted more according to company profits than share price (which offers a value-like adjustment).

By indexing your core you can then concentrate on picking stocks in a satellite portfolio based on your investment ideas alone rather than having to ensure your stock selection combined represents a properly risk-managed portfolio, which leaves you with more time to pursue the things you enjoy!.

If you are a direct property investor, then chances are your core allocation to property is already accounted for because direct property is “lumpy” and investors can generally only afford a few properties as part of a balanced allocation.

For others, I prefer listed property over unlisted property in the core. Investing in illiquid investments brings higher risk and belongs as a satellite activity. For most retail investors a diversified bond exposure should be established through bond funds, either index style or through a fund that focuses on higher credit quality issues.

Possible satellite investments

Satellite investments include specialist sub-classes of traditional assets as well as alternative investments. They can also represent different investment styles. Regardless, they should all work together and complement the overall growth-defensive mix of your core.

Equities

There is substantial evidence suggesting small and low-priced companies can deliver outperformance over larger and higher-priced growth companies over the long term. Local small companies can be bought through both passive and active funds as well as directly, as many readers already do by following David Haselhurst’s column, The Speculator. (Haselhurst returns next week after conducting a site visit).

You can load up on and “tilt” your portfolio to include value companies through funds also or by preferentially buying out-of-favour companies or sectors. Example value companies at the moment include BlueScope Steel, Origin Energy, Tabcorp and Lend Lease.

Many investors choose to access specialist equities, such as those with an Asian or emerging markets focus, through the many managed funds and listed investment companies available. You could just as easily (and more cost-effectively) choose one of the many ETFs available that focus on various emerging market indices or the country specific ETFs that track markets in China, Hong Kong and Singapore. (For more, see Isabelle Oderberg’s feature China's safer investment path.)

When investing offshore don’t forget you need to consider the effect of fluctuating currency. Indeed, your view on whether the Australian dollar is over or under-valued at the moment could be a satellite investing position you take. Based on your view, you could either invest using a currency hedged or unhedged fund if both fund options are available.

Commodities

If you are bullish on commodities (or perhaps bearish on paper money) then you can get an exposure by investing in resource stocks or the commodity itself. For example, if you are a gold bug, you could invest in the ETF “GOLD”. Last year I explained about some of the ways investors can now bet on oil prices (see Hedge your oil futures).

Soft commodities may have a place in an investment portfolio. Unfortunately, many people have discovered the link between the investment and the investor can be buggered up by intermediaries, a problem made apparent by the collapse of Timbercorp and similar managed investment schemes.

Alternative investments

Various share trading strategies could qualify as a satellite activity including “dividend stripping”, “buy/write”, M&A pricing arbitrage and many more strategies that may qualify you to call yourself a hedge fund. Investing in private companies directly or through a fund would also qualify as a higher-risk satellite activity.

Theme-based investing is an interesting area of potential opportunity, which usually requires selling out long before a solution emerges. An example of a “rich” investment idea today could be materials for electric car batteries. Zurich/Lazard’s Global Thematic Share Fund is an example of a fund that attempts to profit from investing in different themes, including those with curious labels such as “anti-matter”, “assets of choice”, “intergenerational assets” or “regulatory change”.

I’m partial to applying the philosophy of Fidelity’s Peter Lynch, of investing in businesses with which you have positive personal experiences. For instance, if you are a grey nomad living off your investments but finding it hard to get into your favourite caravan park, consider being a part-owner of that chain of properties. On the negative side, if you think that the markups at Officeworks and the queues at Bunnings are too big don’t complain, buy Wesfarmers (click here for Roger Montgomery’s view on Wesfarmers). Perhaps the same goes for banks?

Property satellites

Satellite investing in property is not common. In the current environment perhaps one could consider participating in attractively priced (read: sometimes desperate) capital raisings by unlisted property funds. However, note it may be sometime before you see a return of that investment.

Bond satellites

Not everyone will seek to include bonds as a satellite activity. This may because they find bonds too boring or unfamiliar, or because they view bonds as a strictly defensive investment not worth taking higher risk.

In the past I encouraged readers and the government to look more at inflation-linked bonds (see A retail bond wishlist). I consider these so important they should perhaps qualify as a core investment (or perhaps even “the core” for an ultra conservative investor). However, challenges with access and price volatility make them also appropriate as a satellite. You can buy these directly from the government, through one or two bond funds or through a broker.

In my opinion, hybrid securities don’t belong in your core portfolio because of their fluctuating prices. However, they could make an opportunistic satellite investment, especially if you are buying them after others have deserted them. While I’m not a fan, a satellite investment could also include debentures, high yield (read: junk) bonds, distressed debt (read: toxic waste), mortgage funds and private lending.

When managing a range of satellite investments it is important to periodically benchmark returns with like asset classes as well as the returns from your core. This way you can learn whether your extra effort was rewarded or not.

Relative sizes

Few provide guidance on the relative size of the core and satellite portfolios. The exact proportion depends on the relative risk taken in both parts. If, for example, your satellites undertake only high-risk stock selection or trading then maybe your core should be 80% of your portfolio.

Remember that if you have too small a satellite exposure your portfolio’s return will simply track the returns of the broader market; if you have too big a satellite then your returns become more uncertain.

The higher the tax rate you pay on your investments, the larger your core (or more accurately your use of passive investments) should be as active trading strategies have great difficulty beating the market after tax.

Another way to size your portfolio is to have a core of capital set aside to provide a good living standard and a small amount to make it potentially great.

From time to time you may run out of investing ideas. Legendary trader Jesse Livermore was fond of saying that “many losses in Wall Street were caused by traders who felt they needed to be invested every day as though they were working for regular wages”. If you lack conviction that there is opportunity about, then redirect your satellite funds to the core, or hold them in cash if you’re bearish.

The core and satellite philosophy offers somewhat of an intellectual “get of jail free card” to the question of whether active management adds value. More accurately, it promises a way to balance investing in efficient markets and speculating in inefficient ones.

I suspect its greatest benefit is inducing many to access lower-cost and lower-taxed, market rates of returns while at the same time minimising the risk of catastrophic failure from investing in otherwise concentrated, high-risk portfolios.

Doug Turek is the managing director of independent advisory firm Professional Wealth. The range of investments cited here is for illustration purposes only and should not be considered recommendations by the author.