Think dual, not duel, when it comes to active and index investing
Core-satellite investment strategies have much to offer in asset allocation.
Market pundits and financial commentators love to highlight the battle between index and active styles of investing. By battle, we are referring to the growing popularity of broadly diversified funds that seek to track the returns of market indices, which are gaining ground at the expense of traditional active funds where managers typically charge higher fees with the promise of picking investments that will outperform.
When investors read through the great volume that has been written about this so-called battle over the past few years, they might note that these commentators often take a side. Perhaps they think indexing is a superior way for investors to efficiently capture reliable returns over time, or think active managers are truly capable of achieving excess returns above the market and more than justify their higher fees.
What many of these arguments don’t consider is that every investor is different, with varying goals, levels of investment knowledge and appetite for risk. To say that all investors would be better off with a portfolio solely invested in active or index is akin to saying that all investors have the same end-game – which of course couldn’t be further from the truth.
Both index and active strategies are tools that all investors should consider to be at their disposal to help meet their individual goals. The key to finding success with both is having a robust process in place to help choose where to implement index and active strategies to best effect.
One such model that has seen some popularity is the idea of a core-satellite portfolio. This consist of a core of broadly diversified, low-cost index funds that make up the bulk of invested assets, meaning the portfolio is efficient at capturing market returns and is cost effective.
Surrounding this core are smaller, satellite investments in active strategies – which could be actively managed funds or investments in individual shares or other securities – that give an investor some potential opportunity to achieve excess returns.
What underpins the success of this framework? One of the most prominent features is the rule of thumb this gives investors in being able to manage the additional risk that comes with active investment strategies.
The charts below show the theoretical distribution of returns across active funds, which works on the basis that investing is a zero-sum game – for every fund or investor who outperforms the market, there must be at least one other who underperforms.
The idea is that if you added up the returns of everyone invested in the market (both under and over performing), you would get the total aggregate market return, which is what indexing seeks to replicate.
According to zero sum game theory, while an active fund may indeed promise to outperform the market from which it selects its securities, it also runs the risk of underperforming. As the SPIVA scorecards on active management show us, this is a regular occurrence.
This risk of underperformance is what we term active risk – essentially the uncertainty that an active strategy can consistently outperform its market benchmark.
Where a portfolio that combines active and index strategies – essentially the core-satellite concept – can help is by providing some guard rails to investors in terms of keeping their active risk in check.
It is important to note that the core-satellite concept does not come with some prescriptive formula; there is no rule that says the core must be 80 per cent of invested assets and 20 per cent allocated to satellite active investments, for example.
In many respects, core-satellite is more an outcome of good portfolio construction, rather than a one-size-fits-all template. With that in mind, it is important to unpack how an investor can arrive at a core-satellite model that is set to their investment needs.
This is where it’s important for an investor to think about their goals first and their investments second. What are they trying to achieve in life, how much money do they need to do it, and when do they need to do it? These are the kind of questions that should underpin the first steps in determining exactly what an investment portfolio should be built to do.
Having a goal to reach, a timeframe and a realistic view on how much risk should be in the portfolio are the cornerstones of getting started. These points then inform the portfolio’s asset allocation, or the way the capital is apportioned across different types of investments.
At their highest level, asset classes are made up of key categories such as shares, bonds and cash, but can be broken down into sub-asset classes such as global developed-market and emerging-markets shares, US and Australian shares, or US government bonds and Australian corporate bonds.
Deciding how to allocate assets across different types of investments has a big influence on how your portfolio will perform – more so than the decision between index and active funds.
Each asset class can have differing characteristics and different risks and rewards associated with them. For example, equities are generally riskier than bonds, but emerging-markets equities can expose an investor to risks that differ somewhat from those in developed market.
Vanguard’s analysis of performance of Australian multi-asset funds shows that 89.3 per cent of the way returns varied across 600 funds over more than 25 years was explained by each fund’s asset allocation. (Vanguard’s Approach to Constructing Australian Diversified Funds, May 2017).
This is not to say that selection of individual funds or investments within a portfolio is immaterial; it can make a significant impact, but asset allocation is the major driver of risk and returns over time.
That is why deciding on a portfolio’s asset allocation is just about the most critical decision an investor will make. Risk and reward are two inseparable concepts and the more risk an investor feels they are willing to take, the higher their potential returns (and losses).
After your asset allocation is set comes the question of how to implement it. Choosing individual funds or investments is critical at this point and this is where we see the selection of index and actively managed exposure to an asset class start to play out.
Again, while there is no prescriptive measure of how to apportion assets between active and index strategies, investors should have a clear decision-making process in place to help make a choice based on meeting goals.
A helping framework
Vanguard recently developed such a framework to help investors make a decision on active exposure, and because it helps investors to factor in the additional risks inherent in deviating from low-cost indexing to using an active strategy, it aligns well with building a diversified portfolio with a core-satellite structure.
The key factor here is not just being able to identify active investments that stand a good chance of outperforming their market benchmark, but identifying active strategies that may provide outperformance after investment costs. This is where looking for low-cost active options is often a good place to start.
The outcome of using this framework or a similar decision-making process is that it may transpire that exposure to a given asset class is best achieved solely through an index strategy, if no active strategy is able to achieve adequate outperformance relative to costs and an investor’s appetite for additional risk.
While investors’ appetite for active exposure may vary, one thing that does not change is the need for investors to keep their goals in mind, and particularly the level of risk they intend to take on. Without risk, there is no reward in investing, so the question then is how much risk is enough.
In the end, taking on some additional risk through active strategies can be a viable option for many investors, but investors must remember that the trick is to think about combining both index and active strategies for success, rather than choosing one style over the other.
About the author
Robin Bowerman is Head of Market Strategy and Communications at Vanguard Australia.
Robin Bowerman is Head of Market Strategy and Communications at Vanguard Australia.
First-time investors is a great place to start for those thinking of investing in shares or listed funds for the first time.