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How to improve returns and lower fees with a core/satellite strategy.

Photo of Nerida Cole By Nerida Cole, Dixons

As high volatility and expectations for periods of lower returns continue in local and international investment markets, the focus of many investors has turned to reviewing portfolios and looking for alternative ways to manage asset allocation.

Common issues arising from an investment review can include low levels of diversification, high transaction costs associated with an actively managed portfolio (especially where active investment management has failed to outperform the market), and improving returns without significantly increasing risk.

For some investors, these issues can be addressed by implementing a core-satellite investment strategy that aims to incorporate actively managed funds, direct shares and exchange traded funds (ETFs) into the portfolio, while increasing diversification and reducing risk and cost.

Build for long-term results

Core-satellite investing builds on the importance of strategic asset allocation for long-term portfolio results. At its most basic level, asset allocation involves splitting the pool of funds available for investment between different asset classes to achieve desired investment objectives. The way an investment portfolio is split between each asset class will determine characteristics of the portfolio such as volatility, income, growth and security of capital.

Ultimately these characteristics involve trade-offs, and investors who choose to diversify their portfolio will be able to construct a portfolio combining all of these elements at a level suited to their risk appetite and return objectives.

(Editor's note: Read Nerida Cole's last article for ASX Investor Update on strategic asset allocation.)

The core-satellite investment strategy is a commonsense approach to asset allocation, the benefits including less reliance on the selection of outperforming active fund managers, shares and ETFs. The strategy involves using a core of single-sector or diversified index funds for the majority of the investment portfolio's asset selection. The investor could then add actively managed funds, direct shares or ETFs as the satellite component at levels appropriate to their risk profile and desired diversification. The goal of the satellite components is to increase the return of the portfolio above the market return.

The use of an index fund as the core part of the investment portfolio provides the significant advantage of greater portfolio diversification with lower overall transaction and management costs, and lower volatility. Tax efficiencies can also be gained because of lower portfolio turnover and capital gains discounts.

Achieving a broad spread

Index funds aim to achieve the market performance at lower cost to the investor by holding a broad spread of shares within an index (for example, the S&P/ASX 200) in order to track the overall performance of the index. Traditionally, this would have been achieved through an index fund structured within a managed fund platform.

However, with the increased growth in investment products within the Australian investment market, index exposure can also be achieved through ETFs. These enable investors to gain the advantage of exposure to an entire market, index, or sector as well as the ability to trade on the daily market.

For example, investors wanting the core part of their Australian equities allocation to track the S&P/ASX 200 could use SPDR S&P/ASX200 Fund. This ETF contains a pool of shares representing the top 200 companies on the Australian Securities Exchange trading under the code STW. Investors will incur brokerage on buying and selling the ETF, which in most cases will be in line with the buy-sell spread of a managed fund. But the ongoing fee within an ETF will generally be lower than an index fund structured within a managed fund platform.

Given that index funds are passively managed, detailed share analysis and research is not required. In addition, the individual shares that make up an index do not change as often as an actively managed fund, resulting in lower levels of portfolio turnover. These factors result in lower fees and potentially greater tax savings for the investor.

Satellite aim is to outperform the market

Conversely, the aim of the satellite component of the portfolio is to outperform the market through individual asset selection and timing of their purchase. This actively managed portion of the portfolio could be achieved through an actively managed fund, or by holding a more concentrated selection of shares.

Traditionally the higher level of detailed share analysis, research and advice would incur a higher cost. However, investors who do their research will be rewarded by access to improved index structures that seek to outperform the market but maintain costs in line with a pure index fund.

The satellite component of the Australian equities allocation within an investment portfolio could be achieved through the use of a listed investment company (LIC) structure such as the Australian Governance Masters Index Fund Limited (AQF). It invests in Australian companies within the S&P/ASX 100 that have strong corporate governance practices, drawing upon evidence of positive correlations between good corporate governance and investment performance to achieve superior returns.

Investors must note that, like any investment strategy, there are risks associated with core-satellite investing, including market risk and market timing risk. Market risk is where movements in asset markets (for example, sharemarkets) reduce the value of your capital or returns. Market timing risk involves the timing of your investment decision exposing you to lower returns or capital loss. It is important to note that consistently outperforming the market is not easy, requiring a great deal of skill and investment knowledge, and would usually incur a higher cost.

Investors wishing to implement a core-satellite investment strategy should consult their investment adviser to undertake a review and ensure their portfolio is developed in line with their preferred level of risk.

In summary, the core-satellite investment approach provides an opportunity to access the benefits of all the different investment vehicles while reducing risk and volatility through greater diversification, reducing fees and still providing the potential for outperformance.

About the author

Nerida Cole is the Head of Financial Advisory at Dixon Advisory and holds shares in STW and AQF. Dixon Advisory is the manager of Australian Governance Masters Index Fund Limited (AQF).

From ASX

ASX Listed exchange traded funds (ETFs) are an increasingly popular, low-cost tool to rebalance portfolios each quarter. Learn more about the features, benefits and risks of ETFs, and how they can be used in portfolio construction and maintenance.

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