Core Satellite Portfolios For Long-Term Investments

by: MyPlanIQ

Recent market swings and weakness have proven to be difficult for both strategic and tactical asset allocation strategies. For a long-term investor who is concerned about his/her retirement investments, such as 401(k)s, IRAs, 403(b)s and variable annuity accounts, it is thus important to understand the strength and weaknes of the two common strategies.

The concept of core satellite portfolio construction has been adopted for several years by many investment advisers, wealth managers and financial planners. The EDHEC has collected several papers detailing this concept.

The key idea behind the core satellite portfolios is that the traditional, passive (buy and hold) strategic asset allocation allocates capital into a diversified array of asset classes, such as US stocks, foreign stocks, emerging market stocks, Real Estate Investment Trusts (REITs), commodities and bonds. It then performs periodic rebalancing. It is suited for long-term investment; the short-term or intermediate-term risk is too much for an ordinary investor to bear. A portfolio with over 20% peak-to-trough drawdown (i.e. loss) is probably the maximum for many investors.

On the other hand, an actively managed portfolio, while reducing short-term risks, could suffer from a stream of short-term loss. For example, a tactical asset allocation uses cross-asset momentum to dynamically adjust risk asset and fixed-income asset exposure. It works well to protect capital during severe market downturns, such as 2008's, but it could suffer from loss when markets whip saw in a side way fashion. Furthermore, it could forgo a significant portion of profits when markets rise from depressed low levels. The following table illustrates correlations between the two strategies:

Early Bull Late Bull Bear Side Way
Passive Buy and Hold (Strategic Asset Allocation) Good Good Bad OK
Tactical Asset Allocation Miss Good Good Bad

Apparently, these two strategies complement to each other in various market or economic cycles. Furthermore, both strategies have exhibited good long-term average returns. Combining these two strategies in a portfolio should be able to maintain the long term return while reducing the risk or smoothing out the return curve. This practice, known as core satellite portfolio, has been adopted by many wealth managers.

Core satellite portfolios are also more tax-efficient. Furthermore, it is also psychologically easier to accept (thus overcoming the psychological barrier to implement a more active tactical strategy).

MyPlanIQ maintains a core satellite portfolio, Core Satellite Six Core Asset ETFs 25 Core 75 Satellite, which has the following two sub-portfolios:

25% Six Core Asset ETFs Strategic Asset Allocation Moderate

75% Six Core Asset ETFs Tactical Asset Allocation Moderate

for a moderate core-satellite portfolio. It re-balances annually. The two sub-portfolios are the two moderate pre-built model portfolios for a plan called Six Core Asset ETFs that uses only the following six broad-based ETFs:

REAL ESTATE VNQ Vanguard REIT Index ETF Vanguard REIT Index ETF
DIVERSIFIED EMERGING MKTS VWO Vanguard Emerging Markets Stock ETF Vanguard Emerging Markets Stock ETF
Foreign Large Blend VEU Vanguard FTSE All-World ex-US ETF Vanguard FTSE All-World ex-US ETF
COMMODITIES BROAD BASKET DBC PowerShares DB Commodity Idx Trking Fund PowerShares DB Commodity Idx Trking Fund
Intermediate-Term Bond BND Vanguard Total Bond Market ETF Vanguard Total Bond Market ETF
LARGE BLEND VTI Vanguard Total Stock Market ETF Vanguard Total Stock Market ETF

Similar ETFs can be S&P 500 Spider, SPY; MSCI Stocks, EFA; Emerging Market ETF, EEM; Dow Jones REIT index, IYR; iShares Total Bond Index ETF, AGG.

The following table shows how the core satellite portfolio has performed in the past 10 years, compared with the index SPY and the pure SAA or TAA portfolio.

Portfolio Performance Comparison (as of 10/13/2011)

Portfolio/Fund Name 2011 YTD 1-Year AR 1-Year Sharpe 3-Year AR 3-Year Sharpe 5-Year AR 5-Year Sharpe
Core Satellite Six Core Asset ETFs 25 Core 75 Satellite -2.74% -0% -3% 10% 81% 10% 69%
Six Core Asset ETFs Strategic Asset Allocation Moderate -2.85% -1% -17% 8% 39% 5% 20%
Six Core Asset ETFs Tactical Asset Allocation Moderate -2.7% -1% 1% 10% 82% 12% 82%
SPY -3.55% 3% 4% 8% 23% -1% -9%
VBINX -0.7% 3% 14% 9% 46% 3% 10%

Five-Year Chart:

For more detailed performance metrics, including standard deviation, year-by-year performance and maximum drawdown, click here.

To summarize, core satellite portfolio management is well-suited for many long-term investors for their retirement investments, including 401(k)s, IRAs, annuities, and college savings plans. This bodes well for a highly volatile investment environment driven by many factors, including politics, economics and global events.

Disclosure: MyPlanIQ does not have any business relationship with the company or companies mentioned in this article. It does not set up their retirement plans. The performance data of portfolios mentioned above are obtained through historical simulation and are hypothetical.

Disclosure: I am long IYR, SPY, BND.