How to use a Core/Satellite strategy in your share portfolio

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How to use a Core/Satellite strategy in your share portfolio

One of the most popular pathways to achieving Financial Autonomy is through investing in stocks. Stock market investing has a tonne of advantages – ease of diversification, low transaction costs, ease of liquidity, and being highly regulated to guard against investor fraud. Perhaps the number one reason share investment is so popular for those looking to gain choice is its accessibility. You can get started with just a few thousand dollars and easily build your portfolio over time.

A popular stock portfolio strategy is known as the Core/Satellite approach. In this post I’ll be taking you through how this approach might help you build a robust and successful share portfolio.

Let’s start by defining what a Core Satellite approach is, and then we’ll get into how you might use it.

The Core Satellite strategy is a popular way to build share portfolios. Indeed it is an approach we use with the majority of our 1 on 1 financial planning clients. The idea is to have the bulk of your portfolio in more stable, low risk holdings – the Core – and then have several smaller, higher risk (and potentially higher reward) investments to complement these core holdings – the Satellites.

Think of it like a diagram of the solar system. Your core is the sun, and all the planets are your satellites. The sun in our solar system is many magnitudes larger than any of the planets spinning around it. So too your core holdings will be the bulk of your portfolio, whilst your satellites are a series of smaller bets, aiming to boost returns at the margins.

The goal with this strategy is that none of the satellites are so big that if things go badly with any of them, they will destroy your portfolio.

A Core Satellite portfolio construction approach is a risk management strategy. Your goal when investing in shares should be to generate a return in line with the market over the medium to long term. Based on historic numbers this return is likely to be 7-10%. If you can grow your money at this sort of rate over many years, your wealth will grow far faster than the cost of living, providing you with the opportunity in the future to generate some or all of your living costs through either dividends or sell downs.

Novice investors think of stock market investing as more like going to the casino – maybe I’ll walk away with a huge sum, maybe nothing. This is not the way to approach your investing.

A Core Satellite approach helps get you a reliable outcome. And when it comes to successful investing, that is what you want to accomplish. The strategy might also help smooth returns depending on the satellites that you choose. If some are negatively correlated to your core holdings, then when markets turn down, the satellites might provide some positive performance which mutes the fall in value of the portfolio as a whole.

Core Satellite applications

There are several ways you can implement a Core Satellite approach.

Most commonly, you would have one or several broad ETF’s or managed funds as your core holdings. A fund covering the ASX200 in Australia and one covering the United States S&P500 index for instance. Your core might even contain more conservative investments depending on your time frame and appetite for risk – so a bond fund for instance.

It’s with the satellites that things can really vary.

You could have your satellites as individual stocks. Usually these would be small or mid cap companies given you have the large cap stocks covered in your core. Your hope here is that one or two of these smaller holdings prove to be the next Amazon. But you accept that most will probably go nowhere, and the odd one might even crash and burn. That’s okay though because each of these satellites is small.

Another way to go is using ETF’s or funds as your satellites. Under this approach your satellite holdings might be geographically specific – for example Asian stocks. They could be sector specific, like global the bio-tech industry. Or they could be commodities like Gold.

Again, these satellite holdings are more risky than the core investments, but they provide the potential for greater gains and/or to smooth returns in down markets.

You could of course run the entire strategy using individual stocks, building a core of 10-15 stocks, and then adding smaller satellite holdings reflecting your higher risk plays. Typically, an ETF or fund approach for the core is more cost effective, but each to their own.

Common satellite options

As already mentioned, one approach is to select individual stocks for your satellites. You wouldn’t typically have top 10 type stocks as satellites, as you already have good exposure to them via your core holdings. But there might be a specific large cap stock – say Apple or CSL that you feel really strongly about so you have that as a satellite to tilt the overall portfolio in that direction.

Assuming your satellites are small and mid-cap stocks, which is the norm, this is where research is important. A good starting point is to access research either from your broker, or via a service like Simply Wall St.

Good research solutions will allow you to filter based on certain characteristics you might be looking for, eg. a high growth rate or a low PE.

If instead you go the ETF or fund route for your satellites, geographic options might be Asian shares for instance, or even a narrower focus on a specific country like South Korea if you hold a really strong view.

Sector specific ETF’s are popular satellites, with options like healthcare, renewable energy, technology, agriculture, property, or even currencies. For Australian investors, our small local market presents diversification challenges. An investor purely focused on the Australian market would likely end up very mining and banking biased. Sector specific satellites might enable you to get exposure to other sectors, with the potential for greater growth, resiliency, or both.

A final satellite strand could be mid-cap ETFs, or small cap funds. Again, your core has the large cap covered, so maybe you use a fund that specifically covers small caps. The small cap space may be an area where the services of an active fund manager is money well spent. There is plenty of lame ducks in the small cap space and it may be helpful to have a professional sort the gold nuggets from the many worthless pebbles.

Mid-caps are larger businesses, so indexed based ETF’s may well get the job done here. Some of the equal weight ETF offerings provide good mid-cap exposure and could be worth a look.

Well, there you have the core satellite investment strategy. It’s a very popular approach, used by individuals and institutional investors like the Future Fund. Perhaps it’s strategy you can put to use.


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