A core-satellite approach to portfolio strategy explained

The core-satellite portfolio contains both passive and actively traded investments. It is designed to capture both market average returns with the bulk of the portfolio via stock market index ETFs, and potentially above-average returns on the portion of the portfolio allocated to actively managed stocks or ETFs.

It’s up to the investor to decide how much capital they want to allocate to active and passive investing strategies. For example, they may put 80% in the core, and 20% into satellite investments, or they may choose to put more or less in the core. Typically, an 80/20 split is a commonly used allocation.

The core portion of the core-satellite portfolio is composed of stock index ETFs​ that track major indices, such as the S&P 500 and FTSE 100. The ETFs are held passively, meaning they are held for the long-term and not traded in and out of. Regular contributions may add to the position over time.

By not trading this portion of the portfolio, the investor gets the average market return on these funds. For example, over the long run, that is 8% to 10% for the FTSE 100 and S&P 500, respectively. There are also very few trading costs and no capital gains taxes since nothing is being sold.

The core positions don’t have to be stocks. High-grade corporate or government bonds could also be used in combination with stock index ETFs. For example, an investor may decide they want 70% of their portfolio in the core, and that is split between bond and stock ETFs. They put 35% of their funds into government bond ETFs and 35% into stock index ETFs. The other 30% goes to the satellite portion. Adjust these ratios based on personal preference. This is called portfolio allocation.

The satellite portion of the core-satellite portfolio is actively traded and/or is invested in assets that are higher risk but may offer higher returns. Investors can pick and choose their own investments, such as buying individual stocks or more specific ETFs, such as automation and robotics or cybersecurity — whichever stocks or industries (ETFs) they think could do well over the next six months to several years.

Another option is purchasing ETFs that are actively traded by a fund manager, such as the ARK funds run by Catherine Wood, for example. The core portion usually holds the majority of the entire portfolio’s funds, and the satellite portion is composed of the remaining 10% to 30%.

These satellite funds are divided up amongst discretionary investments, which include:

The main purpose of this investing style is to get passive investing returns, with the potential for higher returns via the satellite portion. The other benefits of the core-satellite approach include lower fees compared to a fully actively traded portfolio. Actively traded accounts tend to generate more commissions, and actively traded ETFs tend to charge higher fees than passively managed ones.

There are no capital gains taxes on the majority of the (core) portfolio since the positions aren’t being sold. This allows the gains to compound over time.

The approach can be customised for almost any risk tolerance or time horizon. Investors choose how risky or conservative they wish to be. The core could be very conservative (mostly bond ETFs, for example) with only a bit of extra risk/profit potential in the satellite, or another investor may choose all stock index ETFs in their core and high risk/high reward investments in their satellite. Assuming capital is spread out across various ETFs, the portfolio is often well diversified.

The main drawback of a core-satellite investing strategy is that there are no guarantees the satellite portion will perform better than the core. It may do worse.

The satellite portion also takes up more time for research, placing trades and managing positions compared to purely a passive strategy. Satellite positions also generate commissions, and actively managed ETFs tend to have higher fees.

If buying individual securities, the investor needs access to research tools and the knowledge of how to invest in stocks successfully​.

Here are some steps you can use to implement the core-satellite approach in your own portfolio.

This is how much you are going to allocate to your core and to your satellite as a percentage of your investing capital. A common ratio is 80% core and 20% satellite, although this can be adjusted based on personal preference.

How assets are allocated within the core is very important since these assets are held for the long term. People with longer time horizons until retirement and/or people with a higher risk tolerance tend to put more in stocks than bonds. People with shorter time horizons till retirement and/or a lower risk tolerance tend to put more in bonds than stocks.

For example, someone in their 20s may choose an allocation of 80% stocks index ETFs and 20% bond ETFs. Someone in their 40s may choose a 50% split, and someone in their 60s may opt for 70% bond ETFs and 30% stock index ETFs. Reassess every few years if your allocation is working for you. You can always change it, but you don’t want to do this too often as trading in and out of the core assets will potentially incur fees.

Satellite allocation may change more frequently depending on what you want to invest in at given times. But before allocating funds, now or in the future, it is always wise to sit down and give it some thought, including if now is a good time to invest​ in various assets. Choose how you will allocate your satellite funds. A list of things to potentially invest in was provided above.