|Tuesday, 24 June 2014 07:24|
By Steve Hercenberg, CFA
When I initially started as a Portfolio Manager in the oldest commercial bank in Washington, DC, many years ago, we managed three kinds of assets—cash, bonds, and stocks. The stock portion of a client’s portfolios could be equally divided among 12 to 20 companies. Historically, equal-weighted portfolios tend to outperform market cap-weighted peers in bull markets, but underperform them during bear markets. Similarly, more actively managed portfolios tend to realize higher returns and taxes during bull markets; but, underperform passively managed peers after taxes and expenses during low return or negative return markets.
Major corrections, like we experienced from 2000 to 2002 and from 2007 to 2009, however, have challenged wealth managers to seek a less volatile way to realize consistent returns for their clients. They asked themselves, “How can we realize the best of both worlds?”
One way is to build a portfolio that contains elements of both features—divided into a “Core” and “Satellite investments” as described below.
Part of the portfolio could be passively managed and market-cap-weighted called the Core. The Core would comprise 50% to 100% of the portfolio. The equity portion of the Core could have one or more large equity indexes using a buy & hold strategy, which keeps capital gains taxes and expenses to a minimum. For example, half of the assets of a portfolio dedicated to stocks could be in an index fund or exchange traded fund (ETF) that tracks the S&P 500 or the total stock market. Other examples could include bonds, foreign stocks, real estate and commodities.
By contrast, the actively managed part of the portfolio, called Satellites, aims to get higher returns than the core benchmarks are likely to get after taxes, expenses, and inflation. By contrast with the Core, the Satellites are exposed to a higher risk of potential losses. Examples include high yield bonds, leveraged ETFs, inverse ETFs, foreign bonds, small cap, mid cap, and emerging market stocks.
A conventional view of a Core-Satellite portfolio suggests using index funds for efficient markets and using active managers in areas considered to be inefficient, where the managers might be more likely to succeed.
The Core-Satellite approach provides an opportunity to access the best of all worlds. This flexible package offers better-than-average performance, limited volatility and lower costs that can be designed specifically to cater to your needs.
Subsequent blogs will explore suitable and often out-of-the-box ETFs to build this type of portfolio that seeks to generate outsized returns.
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