Core and Satellite Investing

From The Charleston Mercury, November 15, 2012

Let’s face it. We probably will have at least a few more years of slow growth along with world and investment environment uncertainty. Seems to me you have three choices: sit in cash (and make almost no return while inflation erodes your purchasing power), stay in your current asset allocation of stocks and bonds (and hope your portfolio doesn’t get hit like it did in 2008), or consider a core and satellite portfolio (designed to participate when the market goes up and protect your assets when the market goes down.)

Try to visualize your total portfolio as a car tire, viewed from the side. The rim and everything within is the core; the tire itself is the “satellite” portion. The core is composed of traditional equity and fixed segments seeking to provide higher expected returns with lower risk in a cost-efficient manner. The satellite portion is composed of investments that do not correlate with the traditional markets. The satellite seeks to provide solid returns and provide diversification and downside protection for the overall portfolio.

The core investments are in low-cost, tax efficient passive mutual funds and ETFs. Research, primarily the Efficient Markets Hypothesis, has shown that active management cannot consistently add value through security selection and market timing in efficient (traditional) markets. For the five years ended December 31, 2011, roughly 75% of actively managed mutual funds underperformed their benchmarks. There are three reasons for this: higher fees (operating expense ratios), more transaction costs, and more tax ramifications. Of these, the fees are the biggest culprit. Actively managed funds cost about one percent per year more than passive funds. That one percent shortfall ultimately results in underperformance and costs investors lots of money.

Therefore, a passive strategy in the core portfolio of traditional investments produces, on average, better returns.

On, the other hand, active management, can be more appropriate in inefficient markets. One good example is liquid alternatives. These publicly traded securities are non-correlated to the stock markets, are easily redeemable and may follow hedge-fund like strategies. The liquid alternatives should be considered for the satellite portion of the portfolio. These funds are specially designed to participate in up markets and protect in down markets. They have been shown to be particularly valuable in limiting losses during bear markets.

Consider a core and satellite portfolio, with passive investments in the core and actively managed liquid alternatives in the satellite. You get diversification, lower volatility and a portfolio designed to protect your assets and grow them. Something we all need in these uncertain times.

Les Detterbeck is one of a small number of investment professionals in the country who has attained CPA, CFP®, and CFA designations. His firm, DWM Financial Group, Inc., a fee-only Registered Investment Adviser, has offices in Charleston/Mt.Pleasant and Chicago. Les may be contacted at (843)-577-2463 or les@dwmgmt.com