What is core/satellite investing?

Core/satellite investing is a strategy that divides a portfolio into two components. The core comprises major asset classes combined to achieve a particular risk/reward profile. Satellites have the potential to add value when combined with your core, but may be associated with additional risk.

The reason to adopt a core/satellite approach is to mitigate volatility by ensuring that only a portion of a portfolio is exposed to the most extreme ups and downs.

Building a core/satellite portfolio.

To build an effective core/satellite portfolio, one that maximizes performance for a given level of risk, start with the core. Choose a mix of investments that reflect a range of asset classes, including Canadian equities, U.S. equities, international equities and fixed income investments.

Then enhance the portfolio with satellites. Consider the potential impact on risk and return when you include asset classes and individual securities that aren’t represented in your core.

How do ETFs fit in?

Often, core/satellite investing is used exclusively with actively managed products. For example, the core might consist of a range of balanced equity funds, while the satellites explore historically riskier small-cap or emerging market equities. But core/satellite investing can be an even more powerful strategy when Exchange Traded Funds (ETFs) are added to the mix.

Some ETFs that provide exposure to major asset classes, such as Canadian and U.S. equities, can be part, or all, of the core investment of a portfolio. Other ETFs can also provide exposure to asset classes that are more difficult to access, such as U.S. high yield bonds. These are typically used as satellite positions in portfolios.

The benefits of a core/satellite approach incorporating ETFs.

Maintaining core and satellite exposure to indices through ETFs allows you to benefit from active manager outperformance, while minimizing the impact of underperformance. Investors also benefit from:

• Ease of diversification. ETFs offer exposure to markets that may be expensive to invest in or difficult for fund managers to outperform.
• Proven strategy. Institutional investors, which manage pension plan assets, have a long history of using indexed investments to improve risk-adjusted returns.
• Lower costs. ETFs have significantly lower management fees than actively managed funds.