Core – Satellite Investing

Posted: 15th October 2018

Guide to Core-Satellite investing

What is Core-Satellite investing? Investopedia definition…

Core-satellite investing is a method of portfolio construction designed to minimize costs, tax liability and volatility while providing an opportunity to outperform the broad stock market. The core of the portfolio consists of passive investments that track major market indices, such as the FTSE 100 Index. Additional positions, known as satellites, are added to the portfolio in the form of actively managed investments.

Core investing

These assets are designed to be managed in a passive fashion. Passive investing is a style of management that mirrors market indices. Followers of passive management believe in efficient market hypothesis. This essential means that a market incorporate and reflect all information, meaning individual stock picking is not an effective strategy.

Here is a list of the type of investments you would typically hold as core investments…

Bonds

Passive investors typically use bonds for their income-generating properties. The idea of this approach is that bonds are assumed to be safe, predictable sources of income. Buying and holding bonds involves purchasing bonds and holding them to maturity. Cash flow from the bonds can be used to fund income requirements or reinvested in the portfolio. In a passive strategy, there are no assumptions made as to the direction of future interest rates and any changes in the current value of the bond due to shifts in the yield are not important.

ETFs

Passive ETFs represent a large portion of fund flows over the past two decades. Their popularity in the US particularly has exploded.

Components of ETFs are determined by the underlying index or sector. For instance, a FTSE100 ETF would invest in individual components to replicate the performance of the index. There is low turnover within the fund because assets move in and out of the fund at a slower pace. ETFs operate in a similar way to investment trusts in that they reset at regular intervals, they do differ in that they can be traded freely throughout a normal trading day.

Equities

Stock markets are secondary markets, where existing owners of shares can transact with potential buyers. Some stock markets rely on professional traders to maintain continuous bids and offers since a motivated buyer or seller may not find each other at any given moment. These are known as specialists or market makers. A two-sided market consists of the bid and the offer, and the spread is the difference in price between the bid and the offer.

Here are some equity strategies we use…

Value Investing

This involves picking stocks that are believed to be ‘undervalued’ by the market. Typically, investors seek to profit from perceived irrational moves on stocks. This could be caused by profit warnings, broker downgrades or adverse news that is believed to be an over-reaction.

Weekly Chart on Randgold Resources highlighting the steep downtrend followed by a move higher.

Range trading

A trading range occurs when a security trades between consistent high and low prices for a period. If stocks consistently trade within well-established ranges, then traders can buy with the price reaches support and sell with the prices reach resistance.

Weekly Chart on GlaxoSmithKline highlighting the large range.

Momentum trading

Momentum investing seeks to take advantage of market volatility by taking short-term positions in stocks going up and selling them as soon as they show signs of going down, then moving the capital to a new position. To be successful in timing the waves of momentum it is especially important to have tight risk controls on positions and use stop losses and take profit limits.

Weekly Chart on Halma highlighting the strong trend.

Managed Portfolios

We run a UK Long only growth portfolio which is an equity focused discretionary program. The model is based on a factor based quantitative ranking model, which considers over 20 different metrics.

Once potential candidates have been identified we will undertake an additional layer of technical analysis before deciding to invest. We operate within the FTSE100 universe to ensure we are only investing in the most liquid securities. The portfolio is rebalanced monthly to keep the stock selections current.

 

Benefits of Core Investing

Low fees – There are no management fees, as there is no one managing the picks. Passive funds simply track benchmarks.

Transparency – Access to what is held within certain funds is public information. There is always complete transparency of where your money is invested.

Tax-Efficient – The buy and hold approach does not typically result in huge gains, meaning capital gains tax is less of an issue.

Weaknesses of Core Investing

Small returns – By definition, passive funds will never beat their benchmarks.

Limited – Passive funds are limited to the performance of specific indices. Investors are also locked in during downturns in the market.

 

Satellite investing

This means investing in assets that are managed with a human element. Active management relies on analytical research, forecasts and the managers judgement in making investment decisions. The belief here is that it is possible to profit from the stock market through several strategies that identify mispriced securities. The goal is to produce better returns than those of passively managed index funds.

Here is a list of some of investment types and strategies you could employ as satellite investment.

CFDs can be used to trade a variety of strategies, here are a few that we use…

Earnings plays

Companies release earnings on a quarterly basis and these releases are keenly watched to see if companies have beaten the expectations of the market. Trading using this approach is certain to bring big moves in stocks. Picking the correct direction is less of a certainty. If companies disappoint then the market can gap to the downside and give you little chance to exit the position at a pre-defined risk level (unless using guaranteed stop losses, which we offer). If companies exceed expectations, then you can expect to benefit from sharp moves to the upside.

TP ICAP – Gapped down significantly on results

Card Factory – Gapped higher on results

Short term range plays

A trading range occurs when a security trades between consistent high and low prices for a period. If stocks consistently trade within well-established ranges, then traders can buy with the price reaches support and sell with the prices reach resistance.

Index trading

A stock index is a hugely important part of our financial world, but it is nothing more than a number representing the top shares from an exchange. Most of these are calculated using a capitalisation-weighted average, which means the size of each company is considered. The more a company is worth, the more its share price will affect the index.

However, the Dow Jones and Nikkei are price-weighted indices, where shares with higher prices have more influence. You can freely trade indices to speculate on price movements.

Small Cap or AIM opportunities

Smaller companies have huge growth potential. The most successful large companies started at one time as a small business. Small caps give individual investors the chance to get in at ground level of small companies that are bringing new technology, services or products to market. Small caps are more susceptible to volatility and potentially high returns comes with a much higher level of risk.

The primary advantage of investing in small-cap stocks is significant upside growth potential that is unmatched by mature companies with large market capitalisations.

A bad example of small caps – Jubilee Platinum

A good example of small caps – Aortech

IPOs

An initial public offering (IPO) is the first time that the stock of a private company is offered to the public. These can be excellent opportunities to back companies on their first day of public trading. In some instances, stocks can be swept higher by investors in a state of euphoria as participants scramble for a piece of the action. However, if the initial valuations are too rich they have just as much chance of sinking lower.

A bad example of an IPO – Aston Martin

A good example of an IPO – Boku Inc

Options

The two types of options are calls and puts. When you buy a call option, you have the right but not the obligation to purchase a stock at the strike price any time before the option expires. When you buy a put option, you have the right but not the obligation to sell a stock at the strike price any time before the expiration date. There’s a common misconception that options are confusing and overly complex, but that simply isn’t the case. Trading with options can be extremely useful for hedging market exposure as well as speculating with fixed levels of risk.

Benefits of Satellite Investing

Flexible – Active managers are not required to follow specific indices, instead they can conduct specific analysis into specific areas to try and identify diamonds in the rough.

Hedging – Active managers can trade the market in both directions, meaning they can still provide positive returns during market downturns.

Reduce/Exit Markets – In the event of high periods of uncertainty of volatility an active manager can decided to reduce or completely exit the market if they perceive that the market risk is too great.

Weaknesses of Satellite Investing

Higher costs – Fees in active management are typically higher because each buy and sell has a transaction cost. You are also required to pay the salaries of the research team picking the stocks, which overtime can severely impact on performance in some instances.

Active risk – Managers have the entire roam of the market and aim to select investments that will produce high returns. This is great when they get it right but can be terrible when they get it wrong.

Deciding your risk profile

How do you decide how much to allocate to each of these approaches? Each person will be different, but here are some simple ways to formulate a plan.

Life Style investing

This is a basic way of deciding how to allocate your investments using the core & satellite approach. The older we get the less risk individuals should take as they approach or get to retirement.

If you use your age a gauge, a 55-year old man approaching retirement should allocate 55% of his holdings to safe/passive investments and 45% to active/riskier investments. The ability to make back any losses at the age of 55 is diminished as the investor approaches retirement age. A 35-year old investor should be taking higher levels of risk, allocating 35% of their investments to safe/passive investments and 65% to active/riskier investments. The logic being that in the event of any losses, the 35 year will be active in the work place for many years to come to replenish any losses taken.

Risk profiling

The purpose of the risk profiling exercise is to assess the tolerance of an investor to adverse outcomes. The investment objective favoured by most private clients is to keep pace with the equity markets on their way up and match returns from cash when equity markets are falling. Unfortunately, stock markets cycles are notoriously difficult to predict and, unless a risk profiling exercise is undertaken, investors tend to end up adopting a “balanced” multi-asset class approach as an unsatisfactory compromise.

If you have any further questions or would like to talk to us about Core-Satellite investing then feel free to contact us.