Do you invest on the sly? Well, it’s no secret! A friend recently told me, with some pride, that her small “private” investment account has recently performed better than the much larger portfolio she keeps with a reputable financial advisory firm. She wondered whether she’d do better managing her entire portfolio herself. I told her first off that she needn’t feel guilty about keeping a separate investment account. More importantly, she should keep her portfolios exactly as they are. Here’s why.
The Core-and-Explore technique
It relates to an investment technique called “core/satellite” or “core-and-explore” investing. The philosophy behind this technique is to cut costs, increase tax-efficiency, and mitigate volatility in your overall portfolio with a “core” holding of passive investments, supplemented with “satellite” or “explore” holdings of actively-managed investments.
Essentially, your core holdings should track the average returns of whatever benchmark you’ve chosen to reflect your risk tolerance and financial objectives. It may, for example, be the S&P/TSX Composite Index for equity or the DEX Universe Bond Index for fixed-income. Your core investments, perhaps some broad index exchange-traded funds, will then be those that track this index. And because they are “passive” investments, their management costs should be very low. In addition, because they in effect replicate a major market index, portfolio turnover should also be low, reducing trading costs and tax liabilities (for example, on capital gains). Volatility should therefore also be average, as the core holding will exhibit the same volatility as the underlying index.
Fly me to the moon
In the satellite, or “explore,” portion of the technique, you look for investments where you expect to add value to performance over and above the benchmark in your core holdings. These investments may range from individually selected stocks to ETFs to alternative investments. Such actively managed investments tend to have higher volatility and costs than passive, index-tracking funds, but in return you expect a better-than-benchmark return for your trouble.
My friend mentioned that she had done very well in her “satellite” portfolio. For example, almost exactly two years ago, she had invested in Royal Bank of Canada, which was then trading at $45.85 per share, and along with most other banks and financial institutions, seemed overpriced given the various banking and debt crises around the world. Smart choice! Recently, Royal Bank was trading at $70.53, an increase of 54%. And it continued to pay – and increase – its dividend rate through those two years.
Your core holdings keep you grounded – in reality
It’s unlikely that her “core” portfolio – which is calibrated to her stated risk tolerance and overall longer-term financial objectives – returned 54% in the same period. But the “core” and “satellite” holdings serve different purposes towards the same end. And it’s important not to confuse the two. My friend didn’t mention whether she had losses in other parts of her satellite holdings, which would have offset her marvellous gain in RBC.
A skilful advisor should be able to present a core/satellite portfolio that takes all these issues into account. The core/satellite approach is one of many portfolio strategies advisors use, depending on an individual client’s investment profile and asset allocation strategy. The technique requires a high level of investment discipline and monitoring. And to work effectively, it should encompass a client’s total holdings, including “core” and “satellite” assets in non-registered (or taxable) accounts, as well as registered accounts, such as RRSPs and TFSAs.
© 2013 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.