ETF Strategy 3: Core-Satellite Strategy

Intellidex Jun 27, 2017 5:27:20 PM

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Intellidex and EasyEquities teamed up to run a series of articles explaining how retail investors can use ETFs as part of their broader investment strategies.

The ultimate objective for any investor is to have an optimised portfolio that balances risk and returns to fit the investors’ needs in the most rational way. ETFs can be an excellent help in that objective. In this note we consider how to use ETFs in a “core-satellite” approach to investing. This is a popular approach to asset management – at the core of your investment portfolios you have a low risk, low cost portfolio. Then you take on more risk with a more speculative “satellite” portfolio which you try and beat market returns. .Intellidex stuart-1.jpg

ETFs are a great way to invest in a diverse portfolio without going to the trouble of buying all the shares in a portfolio yourself. Portfolios low risk while providing good returns so are considered more “efficient” in that they balance risk and return better.

 

The market return as a whole is generally called “beta”, a component of returns that can be contrasted with “alpha”. Beta comes from the market as a whole and usually reflects the macro performance of an economy. Alpha is the return that differs from the market and the return that stock pickers are chasing. They believe that they can pick stocks that will outperform the market, so they are trying to generate alpha.

Invest in ETFs

You often hear on news of fascinating price movements of commodities (such as gold, oil, platinum, or iron) or some other financial asset (such as a currency, Krugerrands, Reits, tech stocks or bitcoin).  Usually these random price movements are influenced by geopolitics, the economy, the weather, some technological development or social trends. You may recall that the price of both iron ore and oil climbed to historical highs between 2009 and 2013 but then started falling. They have, though, been recovering since the beginning of 2016. Wouldn’t it have been nice to ride the wave of such a price increase? Of course it would, but the downside can be massive given the almost inevitable price fall afterwards. Using the core-satellite approach you can make tactical (short-to-medium term) changes to your portfolio and participate in such asset price movements.

ETFs provide the easiest way to get the “core” of your portfolio. They are low cost and diversified. The “satellite” part of the portfolio can then be assembled through a normal stockbroking account or some specialised ETFs. The satellite portfolio can be used for tactical investments to take advantage of particular market views.

 

Mechanics of the core-satellite portfolio strategy

Core-satellite investing is based on the premise of splitting a portfolio into two segments. The first is the core. This forms the foundation of the strategy around which the more specialised satellite investments can be added. The core investments account for the main part of the overall portfolio, the actual ratio depends on the amount of risk an investor can tolerate. (See Figure 1 below.)

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The core is made up of one or more ETFs that provide a diverse low-risk portfolio. This element can be shaped by the investor’s overall risk profile. The aim is to deliver a return in line with the market’s performance – the beta return.

The second segment is made up of the satellite. These can be a portfolio of shares, derivatives or other instruments, or more specialised/concentrated ETF portfolios that are designed to deliver excess return (alpha). These carry higher risk and can incur higher fees. A self-invested stock portfolio usually carries higher transaction and custody costs. As a tactical investment, the satellite would be more actively traded, so investors would exit once the short-term opportunity has materialised. It’s important to be disciplined: if the opportunity does not materialise as predicted, close the position.

You can use the satellite portfolio for a variety of strategies – depending on your outlook for various investment themes.

Who can use the core-satellite portfolio strategy?

When it comes to investing, the driving principle is the amount of risk that an investor is willing to take. Naturally, this strategy fits long-term investors, who are willing to take a tactical investment view using a small portion of their funds. This is usually anything between one and three years.

Here are some ETFs that represent distinct themes, which can be used as part of the tactical satellite allocation, as an alternative to assembling equities and other instruments:

Sector-based ETFs

Commodity-based ETFs (note that these are not allowed in a TFSA account)

Growth theme ETFs

Frontier markets ETFs

Real estate ETFs

Dividend focused ETFs (can be used as a soft proxy for value theme)


Invest in ETFs

Background: Exchange-traded funds (ETFs)

Exchange-traded funds (ETFs) are passively managed investment funds that track the performance of a basket of pre-determined assets. They are traded the same way as shares and the main difference is that whereas one share gives exposure to one company, an ETF gives exposure to numerous companies in a single transaction. ETFs can be traded through your broker in the same way as shares, say, on the EasyEquities platform. In addition, they qualify for the tax-free savings account, where both capital and income gains accumulate tax free.

Benefits of ETFs

  • Gain instant exposure to various underlying shares or bonds in one transaction
  • They diversify risk because a single ETF holds various shares
  • They are cost-effective
  • They are liquid – it is usually easy to find a buyer or seller and they trade just like shares
  • High transparency through daily published index constituents

If you thought this blog was interesting, you should also read:

Intellidex Reviews: Using ETF's to allocate your portfolio across assets  

Disclaimer

This research report was issued by Intellidex (Pty) Ltd. Intellidex aims to deliver impartial and objective assessments of securities, companies or other subjects. This document is issued for information purposes only and is not an offer to purchase or sell investments or related financial instruments. Individuals should undertake their own analysis and/or seek professional advice based on their specific needs before purchasing or selling investments. The information contained in this report is based on sources that Intellidex believes to be reliable, but Intellidex makes no representations or warranties regarding the completeness, accuracy or reliability of any information, facts, estimates, forecasts or opinions contained in this document. The information, opinions, estimates, assumptions, target prices and forecasts could change at any time without prior notice. Intellidex is under no obligation to inform any recipient of this document of any such changes. Intellidex, its directors, officers, staff, agents or associates shall have no liability for any loss or damage of any nature arising from the use of this document.

Remuneration

The opinions or recommendations contained in this report represent the true views of the analyst(s) responsible for preparing the report. The analyst’s remuneration is not affected by the opinions or recommendations contained in this report, although his/her remuneration may be affected by the overall quality of their research, feedback from clients and the financial performance of Intellidex (Pty) Ltd.

Intellidex staff may hold positions in financial instruments or derivatives thereof which are discussed in this document. Trades by staff are subject to Intellidex’s code of conduct which can be obtained by emailing mail@intellidex.coza.

Intellidex may also have, or be seeking to have, a consulting or other professional relationship with the companies mentioned in this report.

Topics: ETF Tuesday, Education, ETFs

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