Building wealth is a dynamic process. In order to maintain flexibility while achieving investment goals that are in line with one's risk tolerance and investment time horizon, one must construct a portfolio that is adaptable to meet those needs. Robert Broadwell, vice-president, iShares said a core/satellite investment approach can offer this flexibility in structuring a portfolio to meet long-term goals while creating the ability to seize short-term opportunities. Core/satellite investing is a method of portfolio construction designed to minimize costs and volatility while providing an opportunity to outperform benchmarks. Many different types of investors use core/satellite strategies, including pension fund managers, wealth managers, asset managers and private investors. This approach is simply based on the concept of splitting a portfolio into two segments, the largest segment being composed of the core. This forms the foundation of the portfolio around which the more specialized satellite investments can be added. The exact percentage of allocation to the core is typically based on an investor's risk tolerance for under or over-performing a benchmark, or “the market.” The core usually takes the form of index tracking investment products that are benchmarked to major market indexes, such as the Standard and Poor's 500 Index (S&P 500). Implementation of core investments is typically done via an index tracking fund, such as an Exchange Traded Fund (ETF). ETFs are index funds that trade like any listed security on major stock exchanges and like common stocks, they are subject to investment risk and fluctuation in market value. The key benefits of ETFs are that they offer low cost, diversified and transparent exposure to equity, fixed income and commodity indices - as simple as trading a stock. The goal of an ETF is to deliver a return in line with the total return index that the fund aims to track - this is referred to as “beta” or “passive” return. Second, you have the satellites. These are typically more specialized investments which the investor believes will deliver returns beyond index benchmarks - known as “alpha” or ‘active' returns. This can be achieved through exposure to specific markets and typically include investments with higher risk /volatility than are found in the index tracking core. Satellite investments can include specialty investment funds that tend to have higher fees than index funds. The satellites give the investor the opportunity to pursue independent or market-driven investment ideas. Once the core element has been established, you can use the satellite vehicles to take advantage of shorter-term opportunities. Broadwell illustrates how this approach work in practice in order to build more effective portfolios to meet investment objectives. “Let's say that a local GCC investor is US Dollar benchmarked and has employed an investment manager that specializes in GCC listed equity/bonds and physical property. The investor's goal is to increase diversification through exposure to other markets than the GCC, but the investment manager doesn't have the time or the resources to follow single stocks outside the GCC,” he said. The following example shows how this can be achieved. The manger decides to liquidate 20 percent of the investor's portfolio across each of the following asset classes (in equal proportions): cash, private equity, GCC equity and physical property. The manager doesn't have the time or the resources to track individual stocks outside the local market so he decides to use the liquidated cash to construct a new, non-GCC allocation via a core/satellite strategy. From the new allocation the manager will invest 70 percent into core and 30 percent in satellite. For example, the core allocation could be split up between developed and emerging market (excluding GCC) equity and bonds ETFs. The satellite allocation will be equally divided between actively managed developed market equity funds with a history of producing market outperformance. The manager would also use a parallel fund that invests in an actively managed emerging markets fund. The primary and underlying strength of a core/satellite investment structure is how modular its construction is. One can easily tweak specific positions within the portfolio to match a specific risk profile or investment time horizon. The result is a cost-effective core to track “the market” (beta) while allowing for potential market outperformance in the active satellite investments. Active managers can and do provide outperformance, but the question that investors must ask themselves is how consistent that outperformance is, and if the investor is comfortable with the increased risk that long-only active mangers need to take to achieve that alpha. A core/satellite approach enables portfolio managers to set and control risk targets for the different investments made. The decision on the mix of assets across both core and satellite may prove to be the most challenging part of the process, and is another critical part of the asset allocation process. A core/satellite strategy will encourage the consideration of a broad range of possible investment vehicles and products. Investors typically use index tracking funds, actively managed vehicles, hedge funds, direct holdings of stocks/bonds, across various asset classes in which the strategy can be executed. Among these options, broad based ETFs have enjoyed widespread acceptance as a way to implement the core index allocation. Sector and thematic ETFs are commonly finding homes as satellite holdings. Examples here include biotech, technology and emerging market infrastructure indices. Core/satellite in essence is a common sense, low cost, investment approach that provides greater diversification and simplicity. The strategy blends index and active management and essentially becomes a best-of-both-worlds approach, he added. iShares is a global product leader in exchange traded funds with over 410 funds globally across equities, fixed income and commodities, which trade on 16 exchanges worldwide. The iShares funds are attractive to many individual and institutional investors and financial intermediaries because of their relative low cost, tax efficiency and trading flexibility.
