10 Reasons "Core & Explore"
Investment Strategies Yield Higher Returns
By Ken Hawkin
With the advent of Exchange Traded Funds (ETF)s, we
believe there is very little reason for the average
investor to have an equity portfolio consisting entirely
of individual stocks. Using an investment approach called
Core/Satellite or Core and Explore, an investor combines
an index with individual stocks. Typically an investor
might put 50% of his equity portfolio in an ETF that
replicates a market index and 50% in individual securities.
There is no hard and fast rule about the percentages.
However, the greater the percentage of the portfolio
invested in the index, the more the portfolio will behave
like the overall market.
Most Institution Investors
Take a Core/Satellite Approach
Although they would not admit it, most portfolio managers,
take a Core/Satellite approach when managing their Canadian
equity portfolio. Since they are judged against the
performance of the overall Canadian market, they are
always acutely aware of how much their portfolio resembles
and deviates from this benchmark. They will be diversified
across all industrial sectors. The part of their portfolio
that mirrors the overall market could be considered
the “core” and the part of their portfolio
that deviates from the overall market can be considered
the “satellite” or “explore”.
When you hear a portfolio manager say that they are
trading around their “core” bank holdings
or that they are currently overweight oil stocks and
underweight technology stocks or that they have a small
cap tilt to their portfolio, they are essentially taking
a “core and explore” approach.
Reasons to Consider
a Core/Satellite Investment Strategy
We believe the majority of individual investors who
currently hold individual stocks in their portfolio
would benefit by holding ETFs as a core holding and
individual stocks for the balance of their investment
portfolio, for the following 10 reasons:
1. Better Diversification
of Risk
Typically, the average investor who buys stock tends
to have a poorly diversified portfolio. There is often
a concentration in sectors or types of stocks with very
similar risk characteristics. Using an ETF to buy a
“core” position will provide instant diversification
and reduce the overall risk of the portfolio.
2. Easier To Monitor
and Understand
The more stocks in a portfolio, the harder it is to
monitor and understand the risks. There are more investment
decisions that have to be made and more factors to be
considered. With an ETF or Index fund representing a
core position, the number of stocks can be decreased,
resulting in a portfolio that is easier to monitor and
understand. This allows investors to spend less time
managing their portfolio and more time looking for money
making ideas.
3. More Tax Efficient
A portfolio consisting of all stocks will tend to generate
more trading activity as the market and investment outlook
changes. With more trading activity, more capital gains
will be realized and more taxes paid. With a larger
proportion of the portfolio in a single core holding,
there will be fewer capital gains triggered.
4. Lower Transaction
Costs
With fewer stocks, there will be fewer trades and fewer
commissions paid. The small annual management fee of
the ETF representing the core will easily be recouped
by the lower commissions. In an account at a full service
broker, the reduction of commissions could be dramatic.
(This is one of the main reason why investment advisors
do not like ETFs, in addition to the fact that unlike
mutual funds, they do not pay trailer fees.)
5. A Decrease in Volatility
For the typical investor, with an ETF representing a
core holding, the overall portfolio will likely be less
volatile than one made up entirely of stocks.
6. Allows Investor
to Focus His Attention on Money Making Ideas
In a well designed, diversified portfolio, an investor
will have to invest in sectors or stocks that he does
not like, but is required to hold for diversification
purposes. Using an ETF for a core position will provide
the necessary diversification, allowing the investor
to focus on those stocks expected to outperform.
7. Improve Performance
of Portfolio
After costs, over 50% of professional money managers
will, on average, under perform the market. The average
individual investor typically fares worse. Therefore,
by reducing your stock portfolio and replacing part
of it with a core holding of ETFs will more likely than
not improve your overall performance, with less risk
than before.
8. Asset Mix Changes
Become Easier
A change in an investor’s asset mix is easier
to implement by buying and selling an ETF which represents
the core position. If an investor wanted to increase
his equity exposure, the purchase of additional units
of an ETF makes it easy without having to research individual
stocks.
9. Can Implement Sophisticated
Investment Strategies
Investment strategies such as enhanced index strategies,
risk budgeting, portfolio insurance, style tilts, hedging
strategies, tax loss harvesting etc. become easier to
implement with a core and explore approach.
10. Makes You a Better
Investor
The proper implementation of a core/satellite strategy
requires a certain degree of knowledge and understanding
about risk, market indices, benchmarks and portfolio
management techniques. As investors gain the knowledge
and experience of applying a core and explore strategy,
they will in the end become better investors.
Conclusion
With the array of ETFs available, investors need not
own a portfolio made up entirely of individual stocks.
Properly implemented, a core and explore investment
strategy will result in a better designed portfolio
for the typical investor, with lower costs, lower risk
and most likely better long term performance.
For more information, please visit
Second Opinion Investor Services.
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