The ‘Core – Satellite’ Approach to Investing
The ‘Core – Satellite’ Approach to InvestingCombining the Benefits of Both Active and Passive Investing
Neville Giles
Senior Investment Adviser – Shaw and Partners
One of the most enduring and intellectually interesting debates in all of finance is the debate between ‘active’ and ‘passive’ investing. But do investors really need to choose one or the other? In this article, Neville Giles describes the ‘Core – Satellite’ investment approach which combines the benefits of both active and passive investing.
The rise of passive investing has been a fascinating feature of the investment landscape over the past 50 years. It has its foundations in academic research from the 1970s which established what became known as the ‘Efficient Market Hypothesis’. The genesis of this idea is that current prices of financial assets reflect all information that is known about that asset. A corollary of this is that only ‘new’ information will cause a change in prices. Given that what is new is essentially unknowable, the future price of any financial asset is inherently unknowable and therefore effectively random.
Seizing on this academic insight, Jack Bogle of Vanguard Funds famously launched the first retail ‘index’ fund in 1975 which tracked the S&P 500, the most widely used broad market index covering the largest companies listed in the United States. It was the start of index or ‘passive’ investing, and a revolution was born. If share prices are random, and beating an index consistently is difficult, then why not just own the index as cheaply as possible? It is estimated that approximately half of all monies managed by investment companies is now managed to passive strategies.
Active managers, who aim to out-perform the market, have been fighting back ever since. Partly this is obviously self-interested as fund managers earn fees for managing client monies. But it also appeals to investor psychology. Just as everyone wants to get in the fastest queue, every investor wants to ‘beat the market’. It is also undeniable that markets are quite often ‘irrational’ at times swinging wildly between unduly pessimistic and excessively optimistic. As Mr Warren Buffett famously said to a proponent of efficient market theory – ‘if you’re so smart, why am I so rich?’
It is undeniable that in large, liquid, well-covered investment markets, prices are likely to be pretty efficient. With over 50 investment analysts and innumerable fund managers covering a large cap company like Microsoft, it is very unlikely that any one market participant will consistently be able to make genuinely original insights which can be profited from.
But it is also true that there are several areas of markets where specific factors or strategies have generated consistent out-performance over time. Most passive strategies focus on the large cap indices like the S&P 500. But academic research has suggested several areas outside of large caps where market anomalies exist. Examples include smaller companies, foreign companies, lower liquidity assets, and assets with low price / book ratios. Employing a fund manager to systematically exploit these anomalies could be highly beneficial to investors over time. Also taking an active approach allows investors to express specific market views, implement socially responsible viewpoints, or target evolving demographic, economic and social changes,
Enter the Core-Satellite approach. It is an investment approach that combines the benefits of index funds including lower costs and broad diversification with actively managed funds offering potential for outperformance.
At its foundation, the “Core” of the portfolio typically consists of broad-market, low-cost index funds or Exchange Traded Funds. These passive investments are designed to track major benchmarks like the NZX 50, the S&P 500 or MSCI World Index. The goal here is to achieve broad diversification, minimize costs, and deliver market-matching returns. An investor is trying to capture the ‘beta’, or market return, as cheaply as possible. Why pay an active manager >1% per annum to simply deliver the market return?
Surrounding this core are the so-called “Satellites”. These are smaller, actively managed funds aimed at generating ‘alpha’ or market beating returns. The satellite funds could include sector-specific funds, thematic investments, value managers, small and mid-size cap managers, infrastructure assets, emerging markets and so on. Active managers can also, ironically, exploit the pricing anomalies that passive investing flows inevitably create as companies are added or removed from market indices. As indices are market cap weighted, a passive investor automatically has a higher weighting to the biggest companies irrespective of their valuation. As a company gets more and more over-valued, a passive fund is forced to buy more and more share – the exact opposite of buying low and selling high.
The core-satellite model offers a practical compromise in the debate between active and passive investing. By combining the strengths of both active and passive styles, investors can build a robust diversified portfolios tailored to their goals, risk tolerance, and market outlook. It’s not about choosing sides — it’s about using both intelligently.
Interested in implementing a Core-Satellite strategy for your investment portfolio? Get in touch with Neville Giles to start the conversation on how New Zealand based investors can blend active and passive strategies.
Neville Giles
Senior Investment Adviser – Shaw and Partners
