Asset allocation and risk management are widely recognized as being the keys successful investing, whether via mutual funds in your 401k or in a brokerage account for individual stocks. Keeping your investing risk low is the best way to limit losses and maximize returns.
In fact, studies have shown that asset allocation policy is responsible for more than 90% of the variability of portfolio’s return over time. Today, individual investors have more opportunities than ever before to use asset allocation to help protect their portfolios from market volatility, while reducing overall risk levels.
This can be done through a core-satellite strategy. While the idea is simple, the strategy formalizes some the allocation and selection methods. This makes it easier for individuals to determine what combination provides better returns over time compared to their risk levels.
Mutual Fund Investing – What is a Core-Satellite Strategy?
A basic goal of the core-satellite strategy is to increase diversification and improve risk adjusted performance. This can be accomplished by adding satellite positions in assets which have low correlations to the core portfolio.
A 10% to 20% satellite exposure is common, with very few satellite allocations exceeding 30%. Of course, these exposures can be tailored to fit an investor’s risk tolerance level. Satellite positions typically have a higher investment return and standard deviation, while the core portfolios are lower risk, lower standard deviation.
The core-satellite strategy applies portfolio diversification in two different ways:
One version uses a core portfolio largely comprised of stock funds supplemented with satellite positions in ETFs, mutual funds or individual stocks.
A second version, advocated by institutional portfolio strategist Martin Leibowitz, uses a core portfolio comprised of alternative assets to produce out-performance (alpha), with stock and bond positions used as “swing assets” to customize the portfolio. He has also written about “active extensions,” a variation of long-short strategies, which use a long-only portfolio combined with a percentage of the portfolio (for example, 30%) which is sold short. This results in a 130-30 strategy, but since this strategy requires active monitoring of betas, alphas and trading, it is designed for institutional applications.
The strategy can be further customized by using combinations of active and passive investments in the portfolio, including low-cost index funds as the core. For more risk-tolerant investors, you can under- or overweight different asset classes or add leveraged ETFs.
Here are some examples of core-satellite strategies using low-cost funds as the core position, complemented by ETFs or other mutual funds.
Conservative 401k Strategy
Core Fund – Oracle Mutual Fund (Cusip 68404T 105): The Oracle Fund uses a quantitative evaluation process to screen a universe of 2,800 stocks into a portfolio of 20 to 60 growth-oriented, dividend paying stocks. According to portfolio manager Laurence Balter, the fund is not sector or market cap specific, and has a beta of 0.7. Portfolio allocations are evenly split between dividend paying and growth-oriented equities. When a stock drops in rank due to certain proprietary factors it is eliminated from the portfolio and replaced with one that is rising in our ranking criteria. Some equities can be held for very long periods of time, and others may be held for just a few weeks. The fund has expenses of 1%.
Satellite Fund – Vanguard REIT ETF (NYSE: VNQ): VNQ holds nearly 100 different REITs, and closed out 2010 with a respectable 24% gain. That’s in contrast to the Financial Sector for the S&P 500, which posted a return of 21% in 2010. VNQ has a beta of 1.51.
Satellite Fund – Matthews Asia Small Companies Fund (MUTF: MSMLX): This specialized fund was ranked first in its category and delivered a return of 32% in 2010. If you want Asian exposure, this is it. The fund holds common and preferred stocks of small companies located in China, Hong Kong, India, Indonesia, Malaysia, Pakistan, Philippines, Singapore, South Korea, Sri Lanka, Taiwan, Thailand and Vietnam. That’s all the major economies in Asia, excluding Japan. It carries a 2% expense ratio.
Moderate 401k Strategy
Core Fund – Dreyfus Core Equity I (MUTF: DPERX): This fund is concentrated in the large-cap sector and presents a blend of growth, value and blended styles, combined with a good mix of sector exposures in consumer goods, energy, hardware and healthcare. It is small enough (at $186 million) to move quickly into developing opportunities. About 87% of its equity investments are in the U.S, with the remainder in Europe. Its expenses are a modest 1.01%.
Satellite Fund – Vanguard Emerging Markets ETF (NYSE: VWO): This ETF provides broad exposure to the emerging-markets large-cap universe, but it has been about 60% more volatile than U.S. large caps over the past 16 years. Due to the volatility, the allocation here should be 3%-10% depending on risk tolerance.
Satellite Fund – iShares JP Morgan USD Emerging Market Bond ETF (NYSE: EMB): EMB provides exposure to emerging-markets government and corporate-issued bonds in nine countries. This is a more risky sector, but will perform. The ETF tracks the JPMorgan EMBI Global Core Index which is U.S. dollar denominated.
Satellite Fund – WisdomTree DEFA ETF (NYSE: DWM): If EMB provides exposure to emerging market debt, DWM focuses on dividend paying companies in 16 developed European nations, plus Japan, Australia, New Zealand, Hong Kong and Singapore. DWM tracks the WisdomTree Dividend Index of Europe, Far East Asia and Australasia. It is a fundamentally-weighted Index that measures the performance of dividend-paying companies in the industrialized world, not including Canada and the United States. Companies are included which pay regular cash dividends and that meet other liquidity and capitalization requirements. Companies are weighted in the Index based on annual cash dividends paid.
Tax-Sensitive Mutual Fund Strategy
This strategy has the potential to provide federal tax-exempt income with less risk using ETFs to mimic a laddered maturity.
Core Fund – Fidelity Balanced Fund (MUTF: FBALX): This fund invests approximately 60% of assets in stocks and other equity securities and the remainder in bonds and other debt securities, including lower-quality debt securities. At least 25% of total assets is in fixed-income senior securities, including debt and preferred stock. The fund has a beta of 0.74, to reflect its conservative strategy, and a low expense of less than 1%.
These ETFs are available in various years from 2012 through 2017. S&P says the ETFs will invest in alternative minimum tax-free, investment grade, non-callable national municipal bond debt. They are designed to distribute substantially all of its assets on August 31 of the year in the fund’s name. These ETFs can be constructed to mimic a bar-bell strategy by using the MUAA series for the short-term and PowerShares Insured National Municipal Bond Portfolio ETF (PZA), whose holdings are mostly A+ rated with 50% in maturities of more than 25 years.