about indexing versus active portfolio management. Instead of following one investment approach or the other, the core/satellite approach blends the two. The bulk, or “core,” of your investment dollars are kept in cost-efficient passive investments designed to capture market returns by tracking a specific benchmark. The balance of the portfolio is then invested in a series of “satellite” investments, in many cases actively managed, which typically have the potential to boost returns and lower overall portfolio risk.
Note: Bear in mind that no investment strategy can assure a profit or protect against losses.
Controlling investment costs
Devoting a portion rather than the majority of your portfolio to actively managed investments can allow you to minimize investment costs that may reduce returns.
For example, consider a hypothetical $400,000 portfolio that is 100% invested in actively managed mutual funds with an average expense level of 1.5%, which results in annual expenses of $6,000. If 70% of the portfolio were invested instead in a low-cost index fund or ETF with an average expense level of 0.25%, annual expenses on that portion of the portfolio would run $700 per year. If a series of satellite investments with expense ratios of 2% were used for the remaining 30% of the portfolio, annual expenses on the satellites would be $2,400. Total annual fees for both core and satellites would total $3,100, producing savings of $2,900 per year. Reinvested in the portfolio, that amount could increase its potential long-term growth. (This hypothetical portfolio is intended only as an illustration of the math involved rather than the results of any specific investment, of course.)
Popular core investments often track broad benchmarks such as the S&P 500, the Russell 2000® Index, the NASDAQ 100, and various international and bond indices. Other popular core investments may track specific style or market-capitalization benchmarks in order to provide a value versus growth bias or a market capitalization tilt.
While core holdings generally are chosen for their low-cost ability to closely track a specific benchmark, satellites are generally selected for their potential to add value, either by enhancing returns or by reducing portfolio risk. Here, too, you have many options. Good candidates for satellite investments include less
efficient asset classes where the potential for active management to add value is increased. That is especially true for asset classes whose returns are not closely correlated with the core or with other satellite investments. Since it’s not uncommon for satellite investments to be more volatile than the core, it’s important to always view them within the context of the overall portfolio.
Tactical vs. strategic asset allocation
The idea behind the core-and-satellite approach to investing is somewhat similar to practicing both tactical and strategic asset allocation.
Strategic asset allocation is essentially a long-term approach. It takes into account your financial goals, your time horizon, your risk tolerance, and the historic returns for various asset classes in determining how your portfolio should be diversified among multiple asset classes. That allocation may shift gradually as your goals, financial situation, and time frame change, and you may refine it from time to time. However, periodic rebalancing tends to keep it relatively stable in the short term.
Tactical asset allocation, by contrast, tends to be more opportunistic. It attempts to take advantage of shifting market conditions by increasing the level of investment in asset classes that are expected to outperform in the shorter term, or in those the manager believes will reduce risk. Tactical asset allocation tends to be more responsive to immediate market movements and anticipated trends.
Though either strategic or tactical asset allocation can be used with an entire portfolio, some money managers like to establish a strategic allocation for the core of a portfolio, and practice tactical asset allocation with a smaller percentage.
Note: Asset allocation and diversification are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss.