Go passive with your core portfolio

The core-satellite portfolio approach has become popular among advisors and investors. The core should contain passive exposure and the satellite active exposure to asset classes.

Readers of this column are aware that we prefer the core-satellite approach to investing. Some investors wanted to know why our core-satellite approach differs from others who recommend investing in diversified funds for the core portfolio and thematic funds for the satellite portfolio.

This article explains our argument about why core-satellite portfolio is relevant for individuals. It then shows why we prefer a structure that embraces passive core and active satellite.

The idea of core and satellite portfolio is to separate the returns attributed to the market, or the beta, from the returns attributed to the portfolio manager's active strategy, or the alpha. Separating the alpha and beta decisions is important because fees charged by active funds are far higher than the fees charged by passive funds. An investor should ideally pay active fees only for the alpha strategy, not for the beta decisions.

But most active funds generate returns from beta decisions. This can be observed from the high R{+2} that they have with the appropriate benchmark index; an R{+2} of, say, 0.90 means that 90 per cent of the variation in the fund returns is explained by the variation in the index returns. And as index represents market returns or beta decisions, an investor could be paying active fees for what appears to be market or beta decisions.

Besides, skilful active managers are not many in number.

Remember, generating alpha does not by itself represent skill; for alpha can be measured while skill cannot be. And alpha can be generated by luck as well. This means that investors may find it difficult to select skilful managers because luck and skill can be often indistinguishable. Choosing a wrong active manager can be risky for the investor, as negative alpha can lead to underperformance of the portfolio.

If the reason for the core-satellite approach is to separate alpha and beta, it is logical to argue that the core should be passive and the satellite should be active. Why? Market returns contribute the major proportion of a portfolio's returns. And as the core portfolio represents a significant proportion of an individual's investment capital, the core should be tailored to earn market returns or beta.

Earning beta through passive route is cheaper. Hence, the core portfolio should have passive exposure. The satellite portfolio should carry active exposure to generate alpha returns.

If our argument is tenable, equity core can be created using index funds, preferably on the broad-cap index or ETFs. The bond core can contain, bank fixed-deposits, PPFs and fixed-maturity plans. The satellite portfolio will contain active mid-cap funds and sector funds and commodity exposure through gold ETFs.

We realise that mid-cap active funds contain alpha and beta in the same portfolio. This no doubt goes against the logic of separating alpha and beta decisions. The point is that mass-affluent investors cannot use custom-tailored near-pure alpha products. Such investors require funds that offer higher chances of beating the benchmark. And mid-caps offer more room for alpha generation than the large-caps. Hence, the mid-cap funds.

Conclusion

The core-satellite framework we discussed does not prefer diversified funds and thematic funds for two reasons. One, such funds typically do not have appropriate benchmark to measure alpha. Two, continual style tilts (large-cap bias to, say, mid-cap bias) make it difficult for investors to fit the fund within the core-satellite framework.

Our preference would be to create pure alpha strategies for the satellite portfolio. But such portfolios can be custom-tailored only for high net-worth investors and not for mass-affluent investors. The latter should use style-specific funds and sector funds that offer higher potential to generate alpha even though they contain beta exposure.

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