The “Core-Satellite” method of portfolio allocation seems to have a well-established following, maybe because of its intuitive, sensible framework. Its basic tenets include creation of two high-level investment sleeves. The first is the larger “core” comprising low cost index funds and designed to anchor a portfolio to market beta and the second is the smaller “satellite” allocation comprising vehicles expected to generate portfolio alpha in excess of their higher fees. However, there is not universal consensus on precisely what should constitute the core and satellite sleeves.
The mainstream view holds that asset classes deemed to be more efficient, such as large-cap stocks, ought to make up the core. But an alternative view is that the efficacy of passive investing is not related to market efficiency, and therefore indexing is a solid default strategy for all asset classes, unless an investor possesses particular skill in manager selection. History has certainly shown that indexing mid- and small-cap stocks has been just as effective as indexing large caps—a notion we will further discuss in this paper.
Another issue in core-satellite portfolio construction is how to optimize use of scarce research resources. Since core investments are generally plain vanilla index funds, which are thought to be well-understood, proper attention can be diverted from the core when resources are primarily applied to selection of satellite investments. In other words, investors may have a false sense of confidence in their understanding of what the makeup of a core allocation should be. In reality, many may be uncritically accepting the misleading mainstream view. This is unfortunate because while satellite investments demand a great deal of due diligence and analysis, most risk and return will ultimately depend on allocations, or the lack thereof, to core investments because investment risk and return are largely derived from three factors:
• Market risk and return;
• A portfolio’s level of exposure to the market—in other words, its asset allocation; and
• A portfolio’s effectiveness at capturing market risk and return; i.e., its construction and implementation.
Factor one falls outside of our sphere of control, but advisors and investors directly manage factors two and three. The role of a core allocation is to connect a portfolio directly to the market, and it can be thought of as the main return-generation engine. If alpha-generating satellites are added but the core has not been properly built, it’s somewhat like attaching a flagpole or weathervane to a partially constructed house. You can hang a flag or see the wind direction, but you will not have adequate shelter.