Years of lower equity risk premiums have prompted advisors to begin looking beyond the traditional modern portfolio theory for strategies that can produce heftier returns.Enter the core/satellite design - defined as a commitment to longer-term investing in "core" vehicles, combined with satellites of frequently changed assets that can add to returns.
However, problems with definition, asset selection and implementation can often become blurry. And there remains an ongoing discussion about which assets belong in the core and which belong in the satellites. The concept as introduced several years ago was a market-neutral core with satellites that added market risk.
Two problems with the original model had user Harold Evensky, CFP and principal of Evensky, Brown & Katz, in Coral Gables, Fla., switch the asset allocations. The first problem is the large chunk of market-neutral assets in the core. Retail investors enjoy the constant returns in down markets, but question the lower return in up markets. The second problem is finding suitable assets for a market-neutral core for retail investors.
"The first product introduced with the concept failed miserably," said Evensky, referring to the Barr Rosenberg Market Neutral Fund.
Advisors at Balasa Dinverno & Foltz LLC follow the same pattern. On average, from 55 percent to 60 percent of client portfolios go in the core, which is the Russell 3000 at the Itasca, Ill.-based firm.
Satellites for their clients don't include hedge funds or private equity. "We look at assets for the satellites that potentially add value to the returns," said firm principal Mark Balasa, CPA, CFP.
Both definitions of core and satellite offer a simpler structure compared to the multi-asset-class puzzle of modern portfolio theory. "Even the most experienced investors find it difficult to get their arms around the myriad of possibilities in traditional asset allocation," explained J. Clay Singleton, Ph.D, CFA and professor of finance at the Crummer Graduate School of Business at Rollins College, in Orlando, Fla. "And with traditional mean-variance optimization, the highly sophisticated mathematical techniques are too easily disconnected from the underlying economics."
Singleton's work as a consultant with committees of fiduciaries, and as a fiduciary himself, prompted him to write the book on the approach, Core-Satellite Portfolio Management: A Modern Approach to Professionally Managed Funds, which was published last fall. "The core/satellite is a rational, simple approach that can assist investors to ask the right questions to put things in the right perspective," said Singleton. "Wall Street loves selling ideas, and even sophisticated investors get swayed by fads and fashion."
"The core contains well-tested, broadly available assets, like large cap stocks, and also growth and value stocks," said Singleton. "What's in the core portfolio is the amount of money that will carry the investor through thick and thin."
"The core/satellite approach is the way every retail investor should be investing," Evensky said. "But it's hard to choose investments. We must look at new investments every week, but most are like silly putty - when squeezed it comes out between your fingers."
Launching the satellite
Beyond defining the two parts and choosing assets to match the definitions, advisors must implement the strategy. Singleton came up with a plan: He tells investors to start with determining the level of risk of the entire portfolio. His book then gives an algebraic calculation to arrive at a risk budget. "The exercise has the investor quantify how much they could lose in a finite time," said Singleton. "Then they need to become familiar with the assets that can fit into each category."
Into the core go stocks, both growth and value, and bonds, both corporate and government. Once the core is set, fiduciaries should start thinking about satellite investing. "They should start with what they're familiar with, and then introduce new ideas a little at a time," said Singleton. "Often small cap stocks come first, followed by international stocks. High-yield bonds enter soon on the fixed-income side."
Balasa's firm uses modern portfolio theory for one type of client, and the core/satellite approach for another. They found the strategy in the quest to increase tax efficiency in large, taxable portfolios. Only their clients with portfolios in excess of $1 million fully taxable get core/satellite investing. "None of those elegant academic studies about the value of diversification consider taxes," said Balasa. "We found that any alpha gained in the traditional allocation was getting eaten up by the tax bill at the end of the year."
The change has paid off for clients, but the firm struggled with implementing the strategy. According to Balasa, the new approach reduces overall costs in managing the portfolio, and also prevents overlap of asset ownership. They also met their goal of greater tax efficiency. "We just ran numbers for some new members of one family," said Balasa. "The new method cut their tax bite as a percent of returns by two-thirds."
But his firm struggled with allocating the cores or satellites across the typical multiple accounts held by richer clients. The challenge forced them to develop specialized software that supports some of the success. Five other advisory practices have already purchased the decision tool from Balasa Dinverno.
Despite their success, Balasa doesn't expect that they will use the new approach with all clients. Assets in qualified accounts don't demand the same approach. Even a few taxable accounts don't like the strategy. One reason is that they don't like working with individual stocks, which Balasa puts into the core.
As more and more attention is granted the core/satellite approach, advisors might expect additional help in implementing the plans. Balasa conceded that his firm's new software might make it attractive for some nontaxable investors.
Evensky suggested that leveraged versions of the market-neutral funds could appease the retail investor's psychological need for the bigger core to match market returns.
"The problem of buying suitable assets combined with not enough general experience with this investing means it's hard to throw everything else out and replace it completely with this," said Evensky. "But intellectually, this is where I like to be."
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