If you've been investing for a while, you might have heard the term "core-satellite approach". While it might sound like something out of a sci-fi film, it's actually a simple investing strategy. It's also one that can potentially help you achieve greater long-term investment success.
In a nutshell, the core-satellite approach is a popular strategy to build a diversified investment portfolio. It involves splitting your portfolio into two parts: the core and the satellite. The idea behind this strategy is to manage risk while not having to miss out on potential higher returns.
In this article, we will discuss the core-satellite approach and how it can help your investment portfolio. We will also provide examples to help you understand how this approach might work for you.
A definition of a core-satellite approach
So, what exactly is the core-satellite approach?
Well, imagine your portfolio as a big pizza. The "core" is like the crust and sauce – it's the foundation that holds everything together. This is where long-term investors often choose to invest in low-cost, diversified assets that make up the bulk of their portfolio.
The core part is typically made up of assets that give you broad exposure to the share or bond markets. For example, you can choose between index funds or exchange-traded funds (ETFs). These are low-cost funds that follow broad market indices such as the S&P 500 in the US or the ASX 200 in Australia.
In this type of strategy, core investments could make up the majority of your portfolio, say 70-80% of it. They're designed to give you instant diversification and alignment to market growth over time.
Now, let's talk about the "satellites." These are like the toppings on your pizza. They're the extra bits that make your portfolio more interesting and tailored to your tastes.
Satellite investments are smaller. The assets here are more targeted investments that investors use to add some spice to their portfolios.
Like the topings on a pizza crust, higher-risk satellite investments are meant to complement your core investments. This could include buying individual shares, sector-specific ETFs, or alternative investments like real estate or commodities. Satellite assets are riskier because they are concentrated in a single company, sector or theme. However, these types of assets also have the potential to provide more concentrated returns.
Why a long-term investor might use a core-satellite approach
Why would you want to use this approach? Well, there are a few benefits to consider.
Diversification
By holding a diversified core of index funds or ETFs, you spread risk across many different companies and sectors. This can help protect your portfolio from the ups and downs of any specific share or industry.
Risk management
You can reduce the risk of underperforming the market over the long term if you focus on passively managed funds. It may be tempting to try to beat the market with individual share picks. However, research has shown that most investors are better off sticking with a diversified, low-cost approach.
Long-term focus
Building a strong core holding of index funds or ETFs can set you up for long-term success. These investments are designed to track the overall market over a long time. You don't need to worry about constantly buying and selling individual shares or trying to time the market.
Tax efficiencies
Since the majority of the portfolio is made up of core investments, the overall portfolio tends to be more tax-efficient. Why? That’s because index funds or ETFs generally buy and sell securities less frequently than actively managed funds. This can result in fewer capital gains tax events and, in turn, help reduce the tax costs of your investments. With all of this said, there are never any guarantees in investing. Before making any tax-based decisions, consult a tax professional.
Customisation
Investing in small satellite holdings lets you tailor your portfolio to your interests or values. For instance, if you care about renewable energy, you could invest in companies in the green energy sector.
Lower costs
With a focus on low-cost investments, the core-satellite approach can help you maximise your returns and keep more of your money working for you.
Are there any potential drawbacks to core-satellite investing?
Like any investment strategy, it’s worth considering the possible risks of the core-satellite approach. Here are just a few of them.
Poor performance
A potential drawback of core-satellite investing is that your satellite investments may not perform as expected. Because, remember, there are zero guarantees when it comes to investing. You may also face patches where your core investments are underperforming. During these periods, it’s possible that any positive returns from your satellite investments aren’t strong enough to keep your overall portfolio profitable.
More research required
By nature, satellite investments typically take a lot of time and research. Before and during your investing period, you’ll need to examine your satellite investments. You’ll also likely spend time monitoring, trading and adjusting your satellite investments to ensure they’re performing.
Potential for missed opportunities
A core-satellite approach is effectively a mix of passive investing and active investing. The former comes with the advantage of relatively steady returns, less hands-on management and less risk. The latter has the potential for higher returns and greater flexibility in the face of a fluctuating market. Because a core-satellite portfolio takes the advantages of each strategy and tries to negate the drawbacks, it runs the risk of missing out on their greatest benefits.
Like anything else you invest in, you’ll also need to assess several core components of your core and satellite investments:
Fees. These can impact your overall returns, especially if you’re investing in specialised funds and if your satellite investments don’t perform as expected.
Taxes. Regularly trading your satellite investments can have implications on your taxes.
How to set up a core-satellite portfolio
So, how can you get started with core-satellite investing? Here are the basic steps for setting up a core-satellite portfolio.
Determine your core-satellite ratio
A typical core-satellite ratio is 80-20. That is, 80% of your portfolio is made up of core investments and the remaining 20% consists of satellite investments. However, the ratio you settle on comes down to your personal preference and your appetite for risk. For example, you might prefer to dedicate more of your portfolio to satellite investments in an effort to boost your returns. Or, if you’re risk-averse, you may prefer to have up to 90% of your portfolio made up of core investments.
Choose your core investments
Your core investments are the ones you’ll hold long-term, so it’s absolutely worth thinking about your risk profile when allocating your core assets. While the core component typically favours conservative investments, you might have a higher risk tolerance and choose to allocate some of your core to less stable investments. You’ll also need to think about the makeup of your core investments to ensure they’re diversified. You might have 50% in bond ETFs, for example, and the remaining 30% in index funds.
Pick your satellite investments
Here is where it pays to do your research, because the satellite component of your portfolio is much more variable and will need to be consistently managed. It also typically comes with higher risk. Many investors look into industries that are potentially poised for growth, such as emerging technologies. Or, they might choose individual shares that are currently undervalued. Like your core investments, you’ll also need to consider asset allocation within your satellite investments – such as 10% in an actively managed ETF and 10% in individual shares.
Manage your portfolio
Your core-satellite portfolio will require ongoing management. You’ll need to consistently monitor your investments to ensure optimal performance, and you may choose to trade or reallocate funds within the satellite component of your portfolio on a fairly regular basis. As time goes on, you may also adjust the ratio of your portfolio. Early on in your investing journey, you might have a higher proportion of satellite investments because you’ve got the luxury of a longer time horizon to ride out market fluctuations. Later on, though, you could opt for a more conservative, core-focused approach.
Hypothetical case studies of a core-satellite approach
Now let's look at two hypothetical case studies to see how this approach might work in practice.
Here, you will meet Tito and Gemma. As you will see, the way they divide their portfolio depends on their financial situation and motivation for investing. They also rebalance their portfolio now and then to make sure they stick to their original investing plan.
Tito, 32, electrician
Our first hypothetical investor is Tito, a 34-year-old electrician from Brisbane, Australia. He is married and became a father recently. He started investing in the last few months to secure his family’s financial future.
Tito has decided to use the core-satellite approach. Given his priorities, Tito is focusing more on the core approach because he wants to minimise risks. He's investing 80% of his portfolio in low-cost index funds that track the overall share market. This way, he can diversify his investments and not have all his eggs in one basket.
But why is Tito focusing more on the core part of the approach? Well, now that he has a newborn dependent, he's willing to sacrifice some potential returns for stability. He also knows that investing in individual shares can be risky. Obviously, he doesn't want to take any chances with the wellbeing of his family.
Of course, Tito is still investing around 20% of his portfolio in the satellite part. He's buying some individual shares from companies he knows. He's also thinking about investing in real estate and sector-specific ETFs.
Tito is careful to rebalance his portfolio once in a while. For example, if his innovation-focused ETFs are doing well, he might need to sell some of his individual shares. He will then put that money back into the core portfolio to maintain his 80/20 allocation.
Gemma, 24, software developer
Gemma is earning a great salary as a 24-year-old software developer in New South Wales. She shares an apartment with her partner, who also has a well-paying job in healthcare. They're able to save a lot of money together on many things as a result. So, Gemma is excited to invest and grow her wealth to be able to retire early.
Gemma believes that she knows the tech industry well because of her work experience. This makes her confident in her ability to pick tech shares with the potential for the highest returns. That's why she's using the core-satellite approach. But there’s a twist: she's putting 70% of her money in the core, and 30% in the satellite.
The core part of her portfolio is made up of low-cost, diversified investments like index funds or ETFs. This provides her with stability and diversification. The satellite part of her portfolio is where she's taking more risks. She's investing in individual tech shares that focus on artificial intelligence and cybersecurity.
Why is Gemma willing to take on more risk? Well, she's young and has a long time horizon. As such, she feels that she has a lot of time to recover from any losses.
Gemma knows that investing in individual shares can be risky. But she's not too worried about the short-term volatility of her individual shares. After all, the majority of her money is still in index-tracking investments. She believes that over the long term, the market tends to go up, which will take care of her overall portfolio.
Every so often, Gemma checks her investment plan to ensure it's still in line with her goals and risk tolerance.
For instance, if Gemma's satellite investments have been very successful and now make up 40% of her portfolio, she might choose to sell some of them. She will then use the money to buy more core investments. This move will bring her portfolio back to her desired 70/30 split.
What are some alternative investment strategies to core-satellite investing?
Not sure the core-satellite approach is right for you? Fortunately, there are several other investment strategies to choose from.
Value investing
Think of value investing as heading to a warehouse sale and looking for bargain items that could be sold later on for a higher price. Value investing involves seeking out stocks whose price doesn’t reflect their actual worth and buying them at a discount. Those who use it expect that the price will eventually correct and yield strong returns.
Value investing is a long-term strategy because it can often take a while for the value to correct.
Growth investing
Growth investing is much like its name suggests. It involves looking for stocks that are poised for capital growth, either in the short or long term. Investors then purchase them with the intention of selling them further down the track for a profit.
The catch is that growth stocks don’t deliver dividends. Growth investing is also typically a little riskier because the stocks involved tend to be quite volatile.
Income investing
Income investing is all about establishing a solid income through a diversified investment portfolio – think asset classes like stocks, bonds, trusts and even real estate. This income would be delivered in the form of dividends, bond yields, interest payments, rental payments and other passive streams.
If this sounds a little like the aim of Financial Independence, Retire Early (FIRE), that’s because it is!
Dollar-cost averaging
Dollar-cost averaging is a long-term investing strategy whereby investors make consistent investments at regular intervals, rather than investing with a single lump sum. The idea is that they buy into their investment at different price points to average out the cost.
Dollar-cost averaging can be used by any investor (even first-time investors) because it removes a lot of the guesswork around when to buy.
Buy-and-hold investing
Buy-and-hold investing involves exactly that: buying and holding on to your investments. After establishing your portfolio, you let it sit for a long period with little regard for short-term market volatility or other indicators that impact its value.
The only risk is that investors might miss out on selling their investments at opportune times.
Find the best approach for you
It's important to remember that how well an asset performed in the past doesn't guarantee how it will perform in the future. Also, every investor has different goals and circumstances. You can decide how much of your portfolio you want to put into each part of the core-satellite approach.
Using the core-satellite approach is one way to aim for stability and potential for high returns. However, there are many others (like the ones we outlined above) that you can use to work towards your long-term financial goals.
If you're interested in learning more about investing strategies, check out more on Pearler's blog. We've got plenty of resources to help you get started on your investing journey.
Happy investing!
