Blending caution with opportunism


By Fazila Manjoo
Head of Research at STANLIB Index Investments

Investment markets can move in unpredictable ways and these movements can have a significant impact on savings. Being too cautious may result in the regret of missing a market bull run and being too optimistic can result in large capital losses. In contrarian times, investors are required to balance caution with opportunism.

The story of the stock market is the story of cycles and human behaviour. For example, the over or under-reaction of investors to news that is responsible for market fluctuations in both directions.  Just as securities, asset classes and investment managers go through cyclical phases of good times and bad times, so too does active and passive investing. Some cycles are shorter (three years), while others last much longer (five to ten years).

The core-satellite approach to portfolio construction is a tool that can be used to navigate across investment cycles by blending caution with opportunism. Core strategies aim to provide exposure to market returns. Exchange Traded Funds (ETFs) on broad markets and index funds that track market capitalisation-weighted indices, like the FTSE/JSE Africa Top 40 Index or the S&P 500 Index, are well suited to a portfolio’s core.

Satellites are additional positions in the form of strategies that may provide greater rewards, often at greater risk. Examples of satellite investments are active strategies from skilled managers, direct investments, specialised ETFs and alternatives. What is significant to the core-satellite portfolio construction methodology is that the core and satellite investments chosen are uncorrelated.

 

The core-satellite approach to portfolio construction

 

 

A blended approach also makes good business sense. By allocating the core portion of their assets in an index tracking solution, investors can reduce the risk that they will underperform the market index. In doing so they will also reduce their total investment costs as index tracking investments have much lower costs than their satellite counterparts. The trading activity on an index tracking portfolio is low because trades are triggered when the underlying index to be tracked changes and index changes occur infrequently. The execution costs on the passive portfolios and potential capital gains tax liabilities are therefore minimal. The core-satellite approach enables investors to balance caution with opportunism at an optimal cost.

The weighting towards core and satellite positions in each asset class will depend on the risk profile of the individual investor. A risk adverse investor may invest as much as 80% in the core of a portfolio, while a risk taking investor may limit the core to not more than 50%. Investors also need to decide which assets to use as their core and which satellites to use to complement the core in each asset class. For example, in SA equity a core portfolio that tracks the FTSE/JSE Africa Top 40 index can be complemented by a satellite portfolio with exposure to an uncorrelated active fund, like a small cap fund or private equity fund. More advanced investors can consider prevailing market conditions and dynamically change their allocations to core and satellite through time.

 

Asset allocation with core at the centre and satellites at the periphery

Choosing an active manager’s fund as a satellite is not a simple task. It requires engagement with the manager and unpacking the risks you may be intentionally or unintentionally exposed to. A large number of satellite funds are now available as smart beta funds (also called factor funds) and specialised ETFs. Smart beta funds’ investment process is transparent and risk exposures are explicitly defined by the objective of the funds you invest in.

As outcomes have become critical to investors, these approaches have benefitted due to their ability to deliver customised building blocks at lower costs.


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