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How To Implement The Core And Satellite Portfolio Design?

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by Gavin in Blog
August 23, 2020 0 comments

Today we’re going to dive into further detail on portfolio design and look at the concepts of core and satellite portfolio design.

Enjoy!

Contents

Introduction

The core and satellite portfolio design is a method of constructing your investments in such a way that costs, market volatility, and tax liability are reduced – providing yourself with an opportunity to exceed the broader stock market.

The word core in the name references the sector of your portfolio that contains passive investments that track the major market indexes such as the Dow Jones.

Any additional open positions you have are referred to as satellites and they are added to your portfolio as actively-managed investments.

Construction Of Your Portfolio

 It is good practice to first take a look at the ‘core’ sector of your portfolio.

Your assets should be delegated to investments that are purposed to be managed-passively.

For instance, you may put half of your assets devoted to your core sector into an index fund that tracks the Dow Jones, or even the S&P500.

It is important to do your due diligence as an investor before leaping into an index fund no matter how small the risk seems.

For the satellite sector of your portfolio, or more colloquially know as the ‘actively managed’ sector of your portfolio, your aim is to carefully select investments where a portfolio manager’s expertise delivers you the chance to receive greater returns than those produced by the passive portion, or core, part of your portfolio.

I will include an example below to illustrate this point clearly to you.

In the example, you chose to put 10% of your portfolio into a high-yield bond fund and split the left-over assigned stock funds evenly between a stock fund and a commodities fund.

In this hypothetical situation, your asset allocation break down might look a little something like the table below.

It is important to remember that this is just an example. The ‘core’ sector of your portfolio can track whatever index you deem suitable.

You can even include those indexes’ that globally reflect a style bias for value over growth, growth over value, domestic markets over foreign markets, or whatever you choose.

The best thing about this portfolio design is that it is all up to you – the investor.

In terms of the ‘satellite’ sector of your portfolio, reach for the stars.

The Crux of the Strategy

Volatility, costs, and return on investment are all considerations that need to be made when thinking about implementing this strategy.

Below I will provide an insight into how they specifically relate to this strategy.

Volatility

Understandably, volatility in the market is something in which most investors attempt to avoid.

Within this strategy you are dedicating half of your total portfolio value to passive investments which should reduce the beta of your portfolio (beta is a means of measuring the volatility of the market).

By adding investments in your satellite sector such as commodities funds, which do not follow the movements of the broader stock market, you are further reducing the susceptibility of your portfolio to the volatile markets.

Costs

Passive investments such as index funds are always going to be cheaper than their active equivalents.

The core sector of your portfolio helps to minimize your overall expenditure due to the aforementioned reason above.

Indices don’t change often and since half of your portfolio assets are invested in an index fund, the total value of your ‘core’ sector should only decrease in the event of an index change.

Decreased transaction costs and capital gains tax are also a result of the above reason.

Costs for the ‘satellite’ portion of your portfolio will always be higher because you are actively managing them and trading in and out – each trade incurs brokerage and potential capital gains tax if you make a profit.

Returns

 An active manager will strive to exceed their benchmarks.

Through the process of delegating a small portion of the portfolio to active-management, there is a possibility for the active manager to exceed the benchmark.

This adds to the return accumulated by your entire portfolio, which results in benchmark-beating gains for the portfolio as a whole.

Conclusion

This strategy provides an investor the chance to improve portfolio performance, reduce volatility, and control costs.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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