The core/satellite model approaches investment strategy using the two major viewpoints of stable investment meant to avoid market volatility, and higher risk investment, which is necessary for higher returns. Because of the instability of financial markets, the construction of the core portion of one’s portfolio is necessary to provide a sound base for one’s investments. As the word “core” indicates, these relatively stable passive investments, like ETFs and passive mutual funds, are the bulk of the portfolio in this strategy. The core will often be balanced with other non-equity investments that fluctuate independently from the stock market
Core investment trading is often limited to manage tax losses, and also because this portion of the portfolio is constructed as a long-term investment for the future. With a stable core in place, the satellite portion of the portfolio is intended for higher performance with a smaller percentage of assets. The smaller size of satellite investments limits the overall risk exposure of the client. At the same time, it gives the portfolio manager the opportunity to actively seek returns that outperform their benchmarks.
Unlike core investments, satellite holdings may be traded very rapidly. Tax losses are inevitable in satellite trading, but there is also the enhanced opportunity for short-term gains. Because of the balanced approach of core/satellite portfolio management, such investments should be utilized in any overall financial investment strategy.
Although active portfolios generally provide greater returns, during periods of instability and lower returns, passive long-term investments linked to major market indices offers a secure base to set benchmarks. The satellite investment portion provides opportunity for additional returns exceeding benchmarks. The core/satellite portfolio is constructed to keep tax and other expenses at a minimum – while limiting volatility within the core – and still having an opportunity of outperforming the broad stock market with satellite investments.
When implementing a core/satellite investment strategy, you should consider your financial situation including risk tolerance, and your budget requirements. The performance of core investments, for example, can be constructed with the intention of meeting minimum expected return requirements. Obviously, then the assets used for satellite investments can be seen as “extra” funds granted to your investment manager for alpha performance using higher risk strategies.
Major institutional investors have used the core/satellite approach for years. The concept of managed risk allotting the majority of one’s assets to stable investments, and a smaller portion within one’s risk levels to more active opportunistic investing, is not new.