A core-satellite strategy is a very popular approach to constructing a portfolio. The Investment strategy uses a mix of asset classes to create a diversified balance between long-term and short-term objectives. A core-satellite strategy is a great way to build an investment portfolio that can help to achieve the right risk-adjusted returns by blending both Active and Passive investing.

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What is a core-satellite strategy?

A core-satellite strategy is a practical approach for most private investors who want to manage and invest their own money. It provides a well-balanced mix of long-term and short-term financial goals while rationally managing risk.

The “core” component of the portfolio consists of reliable asset classes that create stability towards the long-term strategy. This includes index funds, ETFs, bonds, cash, REITs, and blue-chip stocks. The core portfolio generally makes up the largest portion of the portfolio, as it is intended to do the bulk of the heavy lifting when looking to create wealth over the long-term.

The “satellite” component, on the other hand, is positioned around the core and takes a more hands-on approach. Satellite positions could be individually selected stocks with the sole aim of generating Alpha. It may be certain thematic themes, regional exposure, undervalued opportunities, high-growth companies, or small-cap stocks where the higher returns can add some upside to the stable core. It plays an important role in bringing the opportunity for slightly higher returns to the portfolio, although it comes with a degree of risk. The satellite weighting should be complementary to the core and is often over a shorter time horizon.

This investment strategy blends both Active and Passive investing. Rather than lean too heavily to one side, incorporating both strategies is often a logical decision.

The overall concept of a core-satellite strategy is to strike a balance between achieving long-term financial goals while being mindful of both risk and reward. The strategy considers everything that rational investing should, such as diversification, cost-effectiveness, risk-consciousness, and tax efficiency.

Why is the core-satellite strategy effective?

Most investors are not interested in complex optimal mix strategies, or volatility analytics and risk profiles when determining the ideal, perfect portfolio structure.

Incorporating the core-satellite strategy when building your investment portfolio is an effective and simple approach for several reasons. Firstly, it involves selecting asset classes or individual securities that are likely to perform well over a long period of time, based on the power of compounding. This creates a diversified and stable core, but it does also limit the portfolio’s upside potential to average returns.

Secondly, allocating a smaller portion of the portfolio to the “satellite” investments can help target additional returns and position the portfolio during different market conditions.

One important issue that is often overlooked with long-term stable passive investing is underperformance. While historical data suggests that the market has consistently produced annualized returns of over 8%, we are cautioned against using the past as an indicator of future performance. Passive investing, however, is grounded in the assumption that past market performance will continue in the future.

What if, 20 years from now, the market’s returns are not what they used to be? With more people investing in index funds and ETFs, and the returns of all investors being averaged out, what if the market only produces a 6% return in 20 years? This is where a core-satellite portfolio can be advantageous. It allows investors to take advantage of the power of compounding and long-term buy-and-hold strategies, while also actively selecting companies that can generate outsized returns.

Using the core as a foundation of the portfolio, designed for stability and to protect wealth, and the satellites for higher returns and growth, combines the best of both worlds. While the satellites may carry some risk, they also offer the potential for investors to achieve higher returns.

Gives investors the chance to be Active & Passive!

The core-satellite investment strategy provides investors who want to be hands-on with the opportunity to practice the art of individual stock selection. The satellite component allows investors to pick companies and “scratch the itch”. Some investors want to actively invest but may have an expertise gap, a time restraint, or simply enjoy sifting through companies but don’t want to do it all the time.

Rather than going all-in on active investing, which can be risky if you don’t know what you’re doing, this strategy helps to hedge your stock picking alongside a much bigger core strategy that builds and protects your wealth. Many investors want to invest in individual businesses, whether they believe they can excel or they want to do something a little sexier than dollar-cost averaging into the same mix of funds for the next few decades.

Successfully picking stocks full-time is not an easy task which requires a lot of dedication. So, building a solid core and then working on the satellites means you can take your time looking for the most compelling opportunities to bolt onto it. An investor is not relying on the intense and consistent process of finding investments day in and day out.

This core-satellite strategy is yet another reason why a lot of investors adopt it. Even seasoned investors I know who have created wealth from active stock selection have shifted to this strategy. They no longer want to manage 20-30 companies and run a vigorous investment process. So, they hold the bulk in the core, which is made up of index funds, bonds, and other reliable assets, while still allocating a smaller portion to the satellite for special scenarios and opportunities for outsized returns.

It allows investors to have a hands-on approach without always having to be hands-on to generate returns.

Is a core-satellite the same as the SAA/TAA strategy?

If you choose to work with a financial advisor, they will typically recommend and execute an SAA/TAA strategy based on your goals, risk profile, time horizon, current financial position, and other factors. This strategy is similar to the core-satellite approach.

SAA stands for Strategic Asset Allocation, and TAA stands for Tactical Asset Allocation.

The Strategic Asset Allocation (SAA) strategy is closely aligned with Modern Portfolio Theory. It focuses on achieving the target asset allocation and often uses rebalancing to maintain the optimal mix in line with the strategy. The strategy is customized to the individual’s needs, risk appetite, time horizon, and current financial position. The asset classes are based on stability and reliability, which may include a property portfolio. The core may consist of property, index funds, bonds, and other income-producing assets, including large blue-chip companies. Risk management is a key focus.

The Tactical Asset Allocation (TAA) strategy works like the Satellite and aims to take advantage of market opportunities wherever they may be. It usually lasts for a shorter 3-5 year period. It may include allocating a small portion to actively managed funds, individual securities, slightly higher risk exposure to alternative asset classes, or other options depending on the individual’s needs. The goal is to look for higher returns and bring growth to the overall portfolio.

While the strategic aspect is long-term focused, the tactical positioning allows for shorter-term opportunities. The goal is to ensure the tactical allocation adjusts the risk of the strategic allocation to improve upon returns.

How to build a core-satellite portfolio?

When building a core-satellite portfolio, it’s important to follow a clear investment philosophy and strategy and know your target asset allocation.

Typically, a core-satellite portfolio consists of 80% core holdings and 20% satellite holdings. However, the exact ratio will depend on your individual circumstances and investment strategy. For example, if you’re just starting out, you may prefer a 90/10 split, while if you have a strong core, you could adjust the ratio to 50/50 over time.

Many investors also choose to keep separate brokerage accounts for each strategy to help build an effective investment system. The way to construct the right core-satellite portfolio is to be very deliberate in what you own. It goes beyond knowing what you own, you must know WHY you own it. Every position and asset class has to serve a purpose otherwise it does not belong.

Have the mindset that investments must deserve a place in your portfolio. Don’t become a collector, just accumulating positions here and there, whether from FOMO, or you brought now to “research later”.

You can use a similar approach to building a portfolio of individual stocks, where investors often have a core of high-conviction positions and smaller weightings to higher-risk opportunities. The key is to stay diversified and have a few strong positions that can help safeguard the portfolio during hard times, while leaving space for generating alpha from special situations.

What goes in the Core part of the portfolio?

The core holdings of your investment portfolio should consist of stable, low-risk assets that can withstand market fluctuations. It is important to align the core with your long-term goals, such as retirement or wealth creation. This is the best place for new investors to start and for seasoned investors to end.

The core should be made up of assets that you would choose to invest in if no other opportunities presented themselves. For instance, if you have accumulated cash and want to invest it, but there are no compelling opportunities in the satellites, you would allocate the money across your core holdings.

The assets that sit within the core usually include Index Funds, managed funds, Exchange Traded Funds, bonds, corporate debt, fixed income, property, and Real Estate Investment Trusts. Some investors also choose to include real estate in this mix.

The core could consist of broad market index funds such as the US S&P 500 or the ASX 200, or an MCSI world index of the biggest companies. The core is often best used with a dollar-cost averaging strategy, combined with periodic rebalancing. Depending on what stage of your investment journey you are in, you may choose to reinvest all dividends.

• Low-Cost ➡️ Lowest fee funds and no trading to reduce overall fees.
• No Portfolio Turnover ➡️ Reduces overall tax liability and lets compounding work.
• Reliable ➡️ Proven and reliable long-term returns based on real empirical data.
• Diversified ➡️ Diverse holdings across regions, industries and market-cap sizes.
• Understandable ➡️ Understand what the product is and Why you own it.

The overall aim is to closely track the market’s performance.

What goes in the Satellite part of the portfolio?

The satellite portion of your investment portfolio involves an active approach to stock selection. It allows you to invest in areas where you believe you can earn above-average returns. This portion of the portfolio provides you with the flexibility to tailor your investments to your preference.

You can think of this as the adventurous part of your portfolio. While it may bring some volatility and risk, it also has the potential for greater returns. Satellites are important for enhancing the long-term returns of your core portfolio.

You can pursue investments that align with your expertise, interests, or personal values. This might include individual stocks, thematic themes, sector-specific asset classes, or alternative investments.

The satellite portion can include a range of investment options, such as small-cap stocks, emerging markets, commodities, high-risk bonds, private equity or hedge fund exposure. The idea is to seek slightly more aggressive, higher-growth, higher-return opportunities to tilt your overall portfolio towards generating more than market returns.

The satellites must still align with your views for growth. Just because the core is well-established does not mean you roll the dice on speculative ideas. The number one goal in investing is Capital Preservation = Never lose money.

• Higher Risk ➡️ Remain vigilant with a strict Investment Process.
• Higher Returns ➡️ Chance to generate Alpha.
• Looking for the 5% ➡️ 5% of public companies bring all the returns.
• Not Speculative ➡️ Satellites don’t mean highly speculative (gambling).
• Diversified ➡️ Still diversify this portion of the portfolio.

The overall aim is to generate above average returns i.e. Alpha.

The flexibility of the core-satellite strategy is ideal.

The strategy’s adaptability depends on various factors, including market cycles. For instance, during a bullish market, the core portfolio captures the overall gains of the market as it rises. Satellites can be positioned in higher growth opportunities to capture even more returns. If a particular industry outperforms others, you can gain further exposure to it.

On the other hand, during a bear market, the core provides protection, stability, and diversification to prevent overexposure to any one asset class. Satellites are equally important here, as they can be deployed to create a defensive position, perhaps in industries that show strength during a downturn. You could take advantage of dislocated prices in deep-value positions. The opportunity is to weight the satellites in counter-cyclical positions, which can further enhance returns in bear markets while also protecting capital.

This strategy offers flexibility and customisation depending on the market, economic conditions, and investor objectives.

Who is a core-satellite strategy suited for?

A core-satellite strategy can be used by a variety of investors. The satellite portion requires research and analysis. Therefore, investors who are starting out may choose to prioritize the core holdings and gradually increase exposure to the satellites as they learn more.

Active investing, in general, should be practised by those who are curious about markets and interested in actively picking stocks. They should have a certain level of understanding and be prepared to learn and layer upon their investment knowledge.

If investors simply want to be in individual stocks without wanting to do all the work involved, they are better off staying in the passive portion long-term and avoiding all forms of active investing.

If you are trying to pick stocks simply to generate long-term wealth, it is better to be consistent with a passive portfolio without taking unnecessary risks. High returns are not a mandate if they expose you to risk, not only from the market but also from not knowing what you’re doing. This is the greatest risk of all.

The drawbacks of using a core-satellite strategy are poor performance of the satellite exposure. It can damage overall long-term returns by repeatedly taking large risks and destroying capital.

Therefore, it’s best to start at the core and build it out. Once you have a plan in place, you can start to venture a little further out in the quest for Alpha.

In Summary…

As a fan of the core-satellite strategy, I believe that simple frameworks are often the best. The core-satellite strategy is a straightforward approach that can be adhered to over a long time frame and is easy to digest why it works. It balances the idea of finding winning companies with the knowledge that long-term compounding consistency also works.

Investment principles don’t change from year to year. What has worked in the past will continue to work in the future. The principles of wealth creation remain the same, and we need to be deliberate, consistent, disciplined, patient, cost-conscious, and balance conservatism with aggressiveness.

I find the philosophy behind the strategy to be most effective, and I will continue to expand on this portfolio management strategy. Although I actively pick stocks and am curious about markets, capitalism, economics, the world, and how businesses operate, the investment process is relentless. It is a profession that requires a lot of effort to generate Alpha.

This is where the strategy can be tailored to suit not only the investor but also the opportunities that present themselves at random times. If there is a solid core that continues to propel forward, you can position the satellites to take advantage of high-return scenarios. Perhaps a market downturn, an undervalued play, a high-growth sector, or an emerging trend. There is no need to be fully vested, only when the probabilities of success are in your favour, then deploy the satellites to go to work.

Over time, I may want to take time to pursue other interests, or pursue nothing, but I will always want to diligently grow my capital as a steward over my wealth. The core-satellite approach comes in handy here as my focus moves in line with other objectives.