What is a core-satellite portfolio?

What is a core-satellite portfolio?

If you’ve only got a minute:

  • Diversification reduces the likelihood that a single asset’s underperformance will drag down your overall portfolio performance.
  • One of the most accessible ways to implement a core-satellite portfolio is to construct the “core” with a combination of index pooled investment funds.
  • The “satellite” can be constructed with pooled investment funds or individual stocks that take advantage of trending themes and sectors that are likely outperform the broader market.

Since the Covid-19 outbreak, retail investors have been playing a larger role in global financial markets. Many first-time investors saw the sharp sell-off in March 2020 as an opportunity to make their first stock purchases. This is a welcome sign as it shows more individuals are turning to investment to make their money work harder.

While this is encouraging, it means more individuals have a higher and wider exposure to market risks than before.

The importance of diversification

Some of you would have heard accounts of new investors making exponential returns on the stock market.

One example is the short squeeze on video game retailer GameStop in early-2021 triggered by retail investors on Reddit’s Wallstreetbets community. As more joined in on the speculative frenzy, GameStop shares traded at extremely volatile levels.

While those who were in early pocketed hefty profits, there are many cases of individuals with heavy losses. Newspapers reports even suggested that some investors almost lost their entire life savings due high levels of volatility.

This is just one example of many on why you shouldn’t put all your eggs in one basket when investing. In other words, don’t put all your money in one place as you could risk it all (or most of it) at once.

Granted, there were opportunities for immense gains on GameStop but they still carried significant risks. It is true that all investments come with an element of risk and the possibility of making a loss, but there are proven ways to mitigate such risks.

It certainly doesn’t mean you should avoid investing or trading in some of these stocks. Instead, you should consider spreading your risks through diversification within your investment portfolio. This can be done though diversification across asset classes, country, industry and by investment style.

Why is portfolio construction important?

Having a portfolio reduces the likelihood that a single asset’s underperformance will drag down your overall portfolio performance, as it may be less correlated with other assets in the portfolio.

A strong and resilient portfolio reflects your investment objectives and risk appetite.

It also enables you to take a long-term view in investing. Moreover, you can rebalance your portfolio (i.e. buy or sell some securities in your portfolio) to capture short-term opportunities that arise from market volatility.

intro to hedge funds

What is the core-satellite approach?

One of the ways you can diversify risk is by taking a core-satellite approach to building your investment portfolio. There are a number of ways to do this.

For retail investors, one of the most accessible ways to implement a core-satellite portfolio is to construct the “core” with a combination of pooled investment funds. This approach sees investors using passive investment instruments like exchange-traded funds (ETFs) and unit trusts that track equity indices (e.g. S&P 500 and Straits Times Index) to build the core of an investment portfolio.

Doing so has advantages for retail investors. Using a combination of ETFs and unit trusts is an easier or hassle-free way to construct an investment portfolio. Moreover, by using such pooled investment funds, retail investors can also minimise trading costs and volatility.

The “satellite” is then constructed with a combination of pooled investment funds, stocks, and bonds that are able to generate returns that are higher than market averages in the short to medium term. The satellites are often considered the actively managed part of the portfolio.

Employing such a strategy also provides flexibility too. As every investor has a different risk appetite, your core-satellite portfolio should be designed according to your individual goals, personal situation, preferences, risk tolerance and the length of time you want to hold the investments for.

Components of the core-satellite investment approach

 

intro to hedge funds

 

 

How does a retail investor construct this portfolio?

The allocation of investible funds to the “core” of the portfolio is likely to be different for each investor. It may range from 50-70% of the investment portfolio depending on your risk tolerance as well as your financial planning aims and targets.

Taking a 50% allocation to the “core” as an example, an investor could invest all of those funds in index ETFs and unit trusts.

This is illustrated below:

intro to hedge funds
*The above table illustrates two examples of what investors can do with to build an investment portfolio. This should not be relied on as investment advice. Investors should do their own due diligence.

Meanwhile, the remaining 50% can be allocated to the “satellite” where funds could be invested in long-term structural trends and themes, which could give you better than normal market returns. This can be done though individual stock picking or though actively managed ETFs and unit trusts.

Investments that form the “satellite” of the portfolio is more short-to-medium-term in nature. Taking the GameStop short squeeze in early-2021 as an example, an investor wishing to take a punt on the stock could have allocated a small proportion of investable funds here. This would minimise overall losses if the “bet” did not play out but sizeable gains if it did.

This is illustrated below:

intro to hedge funds
*The above table illustrates two examples of what investors can do with to build an investment portfolio. This should not be relied on as investment advice. Investors should do their own due diligence.

In sum

A core-satellite approach to constructing an investment portfolio is one of the ways to build a diversified portfolio at relatively low costs compared to individual stock picking. Investors are able to get consistent returns from the core of the portfolio while positioning themselves for better-than-average returns with the satellites.

The core-satellite approach does share many similarities with the barbell strategy, but they are not identical.

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Disclaimers and Important Notice

This article is meant for information only and should not be relied upon as financial advice. Before making any decision to buy, sell or hold any investment or insurance product, you should seek advice from a financial adviser regarding its suitability.

All investments come with risks and you can lose money on your investment. Invest only if you understand and can monitor your investment. Diversify your investments and avoid investing a large portion of your money in a single product issuer.

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