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Explained: The core and satellite approach to investing

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Written by: Paloma Kubiak
28/01/2016
Having an overarching strategy to your investment portfolio can prevent you from being exposed to worrying levels of risk. The core/satellite approach is one such strategy.

Building your investment portfolio will depend on a number of factors, such as your risk profile, your time-horizon and your individual goals.

And in order to maintain a well-balanced and diversified portfolio, a common strategy is to split your assets into ‘core’ and ‘satellite’ investments.

This typically involves investing the ‘core’ of your portfolio in lower cost and lower risk funds while your smaller ‘satellite’ investments tend to be riskier and more for the short-term.

Why core and satellite funds?

The idea behind the core/satellite strategy is to give your portfolio some sort of structure.

Jason Hollands, a managing director at Tilney Bestinvest, says: “Unfortunately we often see ‘DIY’ investors who have no structure to their portfolio but simply long collections of funds, often including niche and high risk investment in areas such as biotechnology or frontier markets, that they have bought on the back of past performance or investment tips.”

He says this can leave investors exposed to inappropriate levels of risk which can lead to “disastrous consequences”.

What should form the core of your portfolio?

Your core holdings should provide stability to your portfolio and should match your risk tolerance and investment horizon, according to Maike Currie, investment director for personal investing at Fidelity International.

One option is to invest the ‘core’ of your portfolio in low cost index funds and your smaller satellite investments in actively-managed funds.

The core will make up the majority of your portfolio so this is a good way of keeping costs down.

Hollands is however cautious about having a core portfolio made up mostly from passive funds – even though there is a lower cost – as this exposes the investor to full market risks.

He says while in theory an index tracking fund is a great way to achieve diversified exposure to the stock market, such as the FTSE All-Share Index which includes 643 companies, it is actually “something of an illusion”.

This is because trackers weight exposure to each company according to its market-cap. As small and mid-caps have historically generated larger returns than large caps, thanks to the weighting, the total representation in your tracker fund is much smaller.

He gives this example: “Out of the 643 individual companies in the index, some 291 (45%) are smaller and 250 (39%) are mid-cap, but the mid-caps get downsized so you end up with 30% of cash in just 10 big companies.”

Both Currie and Hollands agree your core should contain exposure to the UK and other developed markets.

Currie’s fund picks include:

  • US large cap – HSBC American index; Vanguard US equity index
  • UK large cap – Fidelity Index UK
  • International large cap – Fidelity Index World
  • Fixed income – L&G All Stocks Index Linked Gilt Index Trust
  • Europe large cap – Fidelity Index Europe ex UK

Hollands says a core portfolio should be exposed to solid business and should comprise of developed market equities (UK, US, Europe and Japan), government and corporate bonds, commercial property and an allocation to absolute return funds.

Despite the fact that over 70% of the revenues of the FTSE 100 are earned outside of the UK, Hollands says there is “some logic” to having a bias to the home market. This is simply because UK share prices are denominated in pounds and therefore it can make sense to have a chunk of your investments in the same currency where you live.

What should form the satellite of your portfolio?

Hollands suggests satellite holdings might include sector-specific or thematic funds in tech, biotech, frontier markets, water and agriculture or micro-cap funds. He also lists VCTs or EIS investments as well as infrastructure funds.

He adds that investments in global emerging markets and Asia can “add some spice to a portfolio” but warns investors not to go overboard.

“The vast majority of investors should not be considering single country or region specific emerging market funds focused on Russia or South Africa and faddish funds that focus on a narrow theme should usually be avoided,” he cautions.

Currie says satellite investments could include actively-managed property, commodity and emerging market equity funds:

  • Property – Standard Life Investments Ignis UK Property Feeder Class
  • Commodities – First State Global Resources
  • Emerging market equity – Fidelity Emerging Markets
  • Infrastructure – First State Global Listed Infrastructure Securities
  • High Yield – Invesco Perpetual High Yield Fund

What ratio of investments in core-satellite investments should I opt for?

There is no one answer to this as it depends on your risk appetite, goals and time horizon. However, Hollands suggests 90% of investments should be in a core, multi-asset investment portfolio, with just 10% “punting” money in satellite investments for those who “want a bit of excitement around the edges”.

Currie is also cautious and she does not specify a percentage ratio: “Younger investors will typically have a higher risk appetite, so you could assume a higher proportion of satellite holdings, while as you near retirement, it’s often prudent to de-risk your portfolio, perhaps by holding less satellite funds, as you will be looking to draw an income from your accumulated holdings,” she says.

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