Traditional asset allocation focuses on building a portfolio which maximizes expected return while minimizing risk associated with that return expectation. Asset classes are typically limited to equity and fixed income and within each asset class, strategies are defined by nine style categories. Investors build their asset allocation by selecting strategies from these categories and assigning portfolio weights which aggregate to the overall equity and fixed income portfolio weights. For example, the overall target allocations may be 60% equity and 40% fixed income. Within equities, the allocation could be 50% domestic large cap, 25% domestic small cap and 25% international. Within fixed income, the allocation could be 50% core fixed income, 30% foreign fixed income, 10% high yield and 10% short-term fixed income. Implementation is achieved using a variety of vehicles such as open-end, closed-end and exchange-traded mutual funds. Rebalancing is done periodically to bring allocations back to the target allocations. The process is straight-forward, easy to understand but does have drawbacks. The primary drawback is common exposures increase the correlations among the holdings leading to portfolio which are frequently less diversified than owners may believe. Secondary considerations are rebalancing frequency and costs.
Core/satellite asset allocation is an alternative to the traditional approach to asset allocation. This approach assigns strategies to either the “Core” component of the portfolio or to the “Satellite” component of the portfolio. The core component of the portfolio is often low volatility, passively managed strategies. These strategies are intended to anchor the portfolio and are traded infrequently. The core often comprises 60% to 70% of total assets. The satellite component of the portfolio is often comprised of higher volatility, higher expected return strategies and is rebalanced more frequently in an attempt to take advantage of investor insights or expectations for strategy out-performance. This approach has become popular because it has the potential to reduce portfolio volatility without reducing potential return and is typically very cost efficient. Variants on core/satellite include anchoring the core with lower volatility, active strategies and including alternative strategies.
My investment management process involves implementing a core/satellite portfolio. The core component typically consists of lower volatility strategies, often employing hedging techniques. The core will have equity and fixed income exposure and is rebalanced strategically, that is, infrequently. Reasons for rebalancing can include manager or firm turnover, change in management style, and poor absolute and relative performance. The satellite component consists of higher volatility strategies with higher expected return potential. This component is rebalanced tactically, that is, frequently. Reasons for rebalancing include changing underlying fundamentals, trailing total return meeting or exceeding expectations, and better potential return opportunities elsewhere. The typical portfolio has 10-12 positions, including cash, of which 7 to 9 are core and 3 to 5 are satellite positions. The intent with both components is to construct a portfolio of holdings with poor correlations. Hedged strategies and long/short strategies fit very well in this context. Satellite strategies tend to be very specific – a single sector, country, type of security, etc.Consistent with core/satellite theory, I use open-end, closed-end and exchange-traded funds for implementation, leaning toward open-end for most of the portfolio because they typically offer better liquidity, transparency and fees. As the ETF universe continues to expand, I fully anticipate using these vehicles more frequently as well. Unless you’re highly tolerant of volatility and are focused exclusively on maximizing your potential return, give this approach some thought. A well constructed core/satellite portfolio can provide potentially lower volatility and lower expenses without sacrificing expected return.
