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Core-satellite investing

By Dr. Don Taylor ·
Friday, January 10, 2014
Posted: 12 pm ET

I first discussed core-satellite investing in an earlier blog post, "Beat the market, or be the market?" With all of investment forecasts being presented at the start of 2014, it's a good time to bring the topic up again.

Core-satellite investing is where the investor's core portfolio is invested passively in index funds with low management and administrative fees, while the balance of the portfolio is actively managed.

An actively managed portfolio attempts to beat the market. For that to actually pan out, the actively managed investment portfolio has to earn more net of fees than the index portfolio's return net of fees for the investor to be ahead. That's a bit simplistic since benchmarking an actively managed portfolio is more complicated than just comparing its net return to the net return on an index.

What's an investor to do?

Let me start out by saying that no one knows for sure how the different asset classes will do in 2014. For example, there are investment professionals saying you should get out of emerging market investments. Others say it's a good time to get into this asset class. Still others say you can't lump all the emerging market economies together and that you can identify the winners and losers, and invest accordingly. What's an investor to do?

Interest rates are another puzzlement. Longer-term interest rates have crept up over the past year, but short-term interest rates stay low for the foreseeable future, with the Federal Reserve keeping its targeted federal funds rate between zero percent and 0.25 percent.

When interest rates go up, bond prices go down. Since an investor's total return is based on interest payments, plus any capital gains or losses, interest rates moving higher will reduce overall return.

The end of the bull market?

If it's the end of the bull market in bonds, how should investors change their investment allocations to bonds? Some investment professionals argue that investors should shorten the duration/maturity of their bond investments to adjust how they invest in this environment; others consider this akin to trying to time the market.

This takes us back to the core-satellite approach. Investors don't try to time the market in their core portfolio. Instead, they invest to "be the market" and accept that on average they earn that market's return net of fees, and fees are low when they invest in low cost indexed mutual funds or exchange traded funds.

The satellite portfolio is invested based on the investor's "conviction buy list," or those areas where they think the asset class or investment can earn them higher levels of return. This "beat the market" approach typically has higher fees and expenses, so to make it work, the beat yield has to be more than the cost of active portfolio management.

If you think it's an opportune time to invest in emerging markets, overemphasize this asset class in your investment portfolio. Think it's a bad year for these markets? Lighten up on those holdings. Some investors would even look to sell short the asset classes they think will underperform, that is, making a bet that certain classes will fall in value.

What I like about core-satellite investing is that you manage the portfolio to keep fees and expenses low in the part of the portfolio where you're willing to "be the market" and only pay up for active management in that part of the portfolio where you're trying to "beat the market."

What's your approach to asset allocation? Are you willing to be the market, looking to beat the market or are you taking a core-satellite approach to your investments?

Follow Dr. Don on Twitter: @drdonsays.

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