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September 05, 2012 at 05:30 AM
In the years following the financial crisis, advisers have spent a good deal of their professional energy helping investors rebuild damaged portfolios. More than that, they’ve helped clients refine their individual investment strategies. As a positive consequence, ‘portfolio construction’ has become a core competency for today’s leading financial advisers. It’s no surprise that the use of core-satellite strategies has gained meaningful traction along the way. In this period of sweeping change, the ability to craft institutional-grade portfolios for retail investors is an important way for advisers to differentiate themselves in a crowded marketplace.
Orbiting the Objective
Broadly speaking, a core-satellite approach seeks to find an appropriate balance between low-cost market exposure—core—and alpha seeking activities—satellite—through a combination of passive and active strategies. In practice, the more efficient corners of the market, where strategies offer little differentiation, are indexed to track the major benchmarks, e.g., the S&P 500 Index for large-cap domestic equity. The less efficient areas of the market (as well as asset classes with limited index options) are prime candidates for the satellite portion of the portfolio. This alpha-seeking activity would include categories like emerging market bonds, floating rate loans, international small-cap equity, and liquid alternative strategies.
Beyond benefitting from cost efficiency, broadly diversified core-satellite portfolios, by including less-correlated satellite asset classes, will theoretically produce lower volatility than those employing more unrefined asset allocations. This appealing outcome increases the likelihood that an investment objective will be achieved and, just as importantly, the investor will remain on track toward that too-often elusive end. For taxable investors, a passive core adds additional benefits to those already discussed, as it tends to bring down turnover and rebalancing costs.
Satellite Detection
Unlike traditional approaches that rely on highly constrained benchmark-aware strategies, the pursuit of satellites favors opportunistic investment strategies. Managers that can actually migrate across asset class lines or make bigger sector bets and run concentrated, thematic portfolios.That’s okay in the satellite world: it only makes sense to pay for alpha if you have a high degree of conviction that it can actually be generated.
