In the years following the financial crisis, advisers have spent a good deal of their professional energy helping investors rebuild damaged portfolios. More than that, they’ve helped clients refine their individual investment strategies. As a positive consequence, ‘portfolio construction’ has become a core competency for today’s leading financial advisers. It’s no surprise that the use of core-satellite strategies has gained meaningful traction along the way. In this period of sweeping change, the ability to craft institutional-grade portfolios for retail investors is an important way for advisers to differentiate themselves in a crowded marketplace.
Orbiting the Objective
Broadly speaking, a core-satellite approach seeks to find an appropriate balance between low-cost market exposure—core—and alpha seeking activities—satellite—through a combination of passive and active strategies. In practice, the more efficient corners of the market, where strategies offer little differentiation, are indexed to track the major benchmarks, e.g., the S&P 500 Index for large-cap domestic equity. The less efficient areas of the market (as well as asset classes with limited index options) are prime candidates for the satellite portion of the portfolio. This alpha-seeking activity would include categories like emerging market bonds, floating rate loans, international small-cap equity, and liquid alternative strategies.
Beyond benefitting from cost efficiency, broadly diversified core-satellite portfolios, by including less-correlated satellite asset classes, will theoretically produce lower volatility than those employing more unrefined asset allocations. This appealing outcome increases the likelihood that an investment objective will be achieved and, just as importantly, the investor will remain on track toward that too-often elusive end. For taxable investors, a passive core adds additional benefits to those already discussed, as it tends to bring down turnover and rebalancing costs.
Unlike traditional approaches that rely on highly constrained benchmark-aware strategies, the pursuit of satellites favors opportunistic investment strategies. Managers that can actually migrate across asset class lines or make bigger sector bets and run concentrated, thematic portfolios.That’s okay in the satellite world: it only makes sense to pay for alpha if you have a high degree of conviction that it can actually be generated.
In other words, for certain satellite allocations, it’s altogether logical to seek managers that have the flexibility to cross asset class boundaries and the experience to do it well. For instance, if a real-world asset allocation plan calls for a sleeve of international fixed income high yield next to domestic high yield, why not put the domestic/international decision in the hands of a high-yield expert with a global mandate? After all, that manager is out there on the front line and he’s following the day-to-day dynamics of the high-yield markets. Institutions have capitalized on that kind of flexibility for years. According to MSCI research, the initial funding of global equity institutional mandates has grown from a mere 6% in 2000 to represent 38% of all global and international equity initial funding in 2009.
Just make sure the manager you select can exercise all of this nimbleness effectively. A fund’s asset capacity—or lack thereof—can have real impact on the strategy’s opportunity set.
Stay On Course, of Course
So if you’re considering the use of core-satellite techniques to enhance portfolio and risk management capabilities, consider global mandates with nimble, opportunistic managers for the satellite portion of the portfolio. You are, after all, hiring for alpha generation. Keep a close eye, of course, on how these alpha producers combine with each other—you don’t want your managers loading up on the same thing at the same time. Bottom line, the managers representing your clients’ assets in these parts of the allocation equation need to be of the highest quality and closely monitored. A good blend could mean a great outcome.
Author’s disclaimer: Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned.