The best funds for a core-satellite portfolio

There are lots of different ways to build a portfolio, but one of the most convenient is to use a core-satellite approach. This has solid, often passively managed funds at its centre to provide the broad market exposure, with a smaller allocation to actively managed mandates to add outperformance.

The main advantage of this type of strategy is that it can provide extra diversification, while reducing the overall fund management and transaction costs. If done successfully it can result in additional alpha at a lower level of volatility, thereby improving the risk-adjusted returns.

Darius McDermott, MD at Chelsea Financial Services, says that the core-satellite approach involves splitting a portfolio into two parts.

“Traditionally, the core would consist of passive investments that track major market indices like the S&P 500, whereas the satellite would involve selecting actively managed investments to overweight specific sectors of the market that might have above-average returns.”

The theory behind this particular version is that combining active and passive management is an efficient way of achieving a high active share and acquiring excess returns with low fees. However, studies have shown that by limiting the proportion that is actively managed, investors actually miss out on excess returns as most of their money is just tracking the index.

“We prefer to look at core-satellite in a different way: with the core mainly consisting of good consistent investment managers in the main asset classes, while the satellite contains actively managed funds in more niche areas that could either be shorter term tactical plays or longer term positions in specific parts of the market,” explains McDermott.

Those who follow this type of approach should be able to avoid over-trading, with the core being left to compound over the long-term or deliver a specific objective such as income.

A sensible balance

Rob Morgan, spokesperson and chief analyst at Charles Stanley, says that mentally categorising your investments into core and satellite holdings can help to size them correctly and if they become too big from good performance you can then cut them back.

“Sizing is really important so that one area doesn’t come to dominate, especially if it is a really volatile one. It’s critical not to let a single theme or sector take over, which is why higher risk, specialist investments should generally be satellites rather than core holdings for most people.”

Another key element is to avoid the illusion of diversification where you have various flavours of a similar thing rather than a mixture of components with different characteristics. For the core-satellite to work you need to understand which assets will protect you if you are wrong and commit enough capital to those areas.

Over time, the various investments will inevitably perform differently, which means that allocations can become out of kilter, so you have to be prepared to do some rebalancing to keep the strategy on track, selling a little of what has done well and topping up what has lagged.

The rebalancing process will be a lot easier if the number of positions is kept to a manageable amount. This can then be done on a six monthly or annual basis with the aim of ensuring that no individual element of the portfolio dominates the returns.

Size matters

Ryan Hughes, head of active portfolios at AJ Bell, says that it’s important that investors understand what their overall objectives are before they determine an investment strategy to achieve them. They should also think about how involved in the management of the portfolio they want to be.

“Often using a satellite approach requires more involvement as the holdings are likely to be in niche areas and therefore may require closer attention. For many investors I would suggest that around three-quarters is allocated to the core elements of the portfolio as this will be the main determinant of the long-term returns. The main focus can then be on the satellite positions.”

McDermott recommends that investors should build up the core component of their portfolio first by establishing a decent pot of money in good, consistent, mainstream funds. Once that has been done and investors are more confident, they can then start to add satellite holdings, safe in the knowledge that the core part of their portfolio is already up and running.

“The actual mix will depend on the individual investors, their attitude to risk and the size of their investment pot. Some may have 95% in their core component, others as little as 60%,” he says.

A core fund might represent 10-20% of a portfolio, with a satellite being around five percent, although that’s just an example as the actual amounts can vary according to portfolio size and strategy, as well as the nature of the components.

What makes a good core or satellite holding?

Morgan says that coreholdings are typically diversified and broad, like a global tracker that provides a simple and low cost exposure to stock markets around the world.

“Broad passives covering major markets tend to make good core positions as they are low cost and stylistically neutral with no bias to either growth or value. They don’t however diversify across different investment classes, so a multi-asset fund could be a convenient solution.”

Satellites are typically holdings that allow a more personal spin. It could be a fund run by a specific manager with a defined value or growth style, or an area or sector that is considered to have long-term potential.

The key is to avoid closet trackers that are unlikely to generate any meaningful excess return for the portfolio, but will add extra cost. It is best to look for satellite funds in areas where the managers can significantly outperform, such as the small caps or specialist sectors like tech and biotech.

“When you select the funds you should make sure that you understand what each one aims to do and the role that it plays in your portfolio. You also need to be aware of the objectives and risks involved, so check the relevant fund literature before investing,” advises Morgan.

Core investment trusts

Mick Gilligan, portfolio manager at Killik & Co, says that his favourite core holdings are in the flexible investment category and are the multi-asset trusts Capital Gearing (LON: CGT) and Personal Assets (LON: PNL). Both offer a mix of equities, bonds and alternatives such as gold and infrastructure.

“The managers of each of these trusts tend to have very good valuation discipline. I think they would really come into their own if we see an extreme market sell-off at which point I would expect them to increase their equity exposure materially, which should leave them well-positioned for the next 10 years.”

The higher interest rate environment is leading to a reappraisal of the discount rates used to value various assets. As these rates go up, present day values come down, with the most overvalued assets getting hit the hardest. Gilligan thinks there is probably further to go in this process, which makes these more defensive holdings a good option.

Hughes also likes Personal Assets and says that its lower risk approach works well alongside higher risk satellite holdings, such as smaller companies or sector specific funds, which can be used to tilt the overall portfolio towards favoured areas.

“With manager Sebastian Lyon holding cash, bonds, equities and gold in a single portfolio, investors have a low risk, core portfolio that can be held alongside satellite holdings.”

Morgan prefers the Ruffer Investment Company (LON: RICA) that isdesigned to be an all-weather vehicle for the managers to dynamically express their views through a wide range of tools.

“They combine conventional asset classes – global equities, bonds, currencies and gold – with the use of derivative strategies that serve as protection in market downturns. The overall aim is to protect as well as grow, so the balance of different assets is designed to pay off in a variety of economic scenarios and the managers have a strong record of making shrewd macro-economic judgements,” he says.

Core funds

In terms of the open-ended funds McDermott recommends T. Rowe Price Global Focused Growth Equity, which invests in a diversified selection of companies based anywhere in the world, including the emerging markets. The manager builds the portfolio based on key themes, which means that it has considerable potential to deliver long-term returns across all market conditions.

He also likes Rathbone Income, which he describes as a solid core UK equity income fund run by an extremely experienced and long-standing manager.

“It has one of the best track records in the sector for raising dividends annually and the stock selection process is well defined without being overly constrictive. The heavy emphasis on risk management is particularly pleasing,” he says.

Alternatively Hughes suggests the passively managed HSBC FTSE All-World Index Tracker, a low cost vehicle that gives instant exposure to well over 3,000 different stocks across the world. Unlike some of the other global trackers it includes emerging markets and provides an easy way to get access to the largest companies for just 0.13% per annum.

A similar option recommended by Morgan is the iShares Core MSCI World UCITS ETF, which provides straightforward and low cost access to global stock markets. It is highly competitive with an optimised physically replicated strategy and because of its size it tends to be easy to trade with a tight bid-offer spread.

Satellite trusts

When it comes to the satellite holdings, Gilligan says that he would be inclined to focus on areas where valuations have come down sufficiently that they now offer some margin of safety and attractive upside.

“One example would be the Korean preference shares that are accessible via the Weiss Korea Opportunities Fund (LON: WKOF). Its portfolio trades on a PE of less than six times earnings and has exposure to companies such as Hyundai and LG Electronics.”

He says that junior biotech is another area that offers attractive valuations, as it has had a torrid few years and is very out-of-favour. The reason for this is that the market is concerned about the ability of many of the companies to raise cash to progress the clinical trials.

“Syncona (LON: SYNC) has a concentrated portfolio of both private and public biotech stocks and is very well funded with a large cash reserve. Most of its quoted holdings are trading below their cash value and we expect to see a lot of clinical read-outs over the next 18 months.”

McDermott highlights BlackRock World Mining (LON: BRWM), a specialist investment trust that offers exposure to mining and metals companies globally. It has very experienced managers at the helm and is likely to benefit from the move to zero-carbon, while also paying an attractive dividend yield.

Alternatively he suggests the Polar Capital Global Healthcare Trust (LON: PCGH) that invests in healthcare stocks from around the world.

“The managers have produced very attractive returns for the shareholders and we believe their extended investment opportunity should continue to be beneficial for new and existing investors,” he says.

Morgan prefers another specialist vehicle from the same sector, namely the Worldwide Healthcare Trust (LON: WWH). This has been managed by New York-based OrbiMed Capital for nearly 25 years with the firm building up a strong long-term track record.

“WWH is the ideal vehicle through which the Orbimed team can showcase their best ideas and it is well placed to continue to exploit the demographic, socioeconomic and technological tailwinds that the healthcare sector enjoys. It’s an attractive option for adventurous investors looking to harness the growth potential of this complex, fast-changing and higher-risk area.”

Satellite funds

For those who prefer open-ended funds Hughes suggests First Sentier Global Listed Infrastructure, which focuses on companies that provide key infrastructure around the world such as roads, railways and airports, as well as electricity and gas storage.

“The team at First Sentier are well resourced and experienced in this niche area and have excellent relationships with company management and government, which is key given that most of the returns are closely regulated. Infrastructure is often a lower risk element of the equity market and therefore sits as a satellite holding alongside mainstream markets.”

Hughes also likes another sector specific option, the Polar Capital Global Insurance fund. As the name suggests, it has a very specific focus on the insurance market, which is a small sub-set of the broader financials sector.

“The companies look to steadily grow their book value via careful underwriting, while at the same time putting up premiums. Manager Nick Martin has been managing the fund for over 20 years and has delivered excellent returns in a relatively uncorrelated way to global equities.”

Morgan prefers the BlackRock Gold & General fund, which invests in gold and other precious metal-related companies on an actively-managed, worldwide basis.

Shares in gold mining companies are a higher risk way of gaining exposure to the price of gold. They tend to represent a geared play on the precious metal, multiplying the effect of a rise or a fall in the price.

“It’s an adventurous fund for gold bugs who believe the price of bullion will rise over time and that gold miners will provide an extra kicker through their increased earnings, but it should only be a small position in a typical portfolio given its highly specialist and risky nature. The robust investment process and proprietary research could ultimately drive strong long-term returns within the sector,” he concludes.