The evolution of core-satellite portfolios

Produced in partnership with Vanguard.

How financial advisers construct and manage portfolios has evolved over the past decade, influenced by evolving client expectations, product innovation including exchange traded funds (ETFs) and managed accounts, and the rise of asset consultants.

Against that backdrop, a core-and-satellite approach to portfolio construction has emerged as a popular strategy.

According to James McIvor, head of corporate distribution at Vanguard, there are different ways to implement a core-satellite strategy, but one of the most common approaches is to combine a large, stable foundation of market cap-weighted index funds with targeted active exposures around the edges.

This enables advisers to manage risk and costs while customising portfolios by dialling up exposure to growth opportunities that can potentially supercharge returns or adjust portfolio risk.

“There isn’t a single, universal definition of ‘core and satellite’ but we typically see advisers build a low-cost, passive core and add satellites like single stocks and active funds where they see opportunities to outperform, such as in less efficient markets like small caps and fixed income,” McIvor tells Professional Planner.

Historically, investors and advisers have used managed funds for the core of their portfolios and while still popular, there is a gradual shift to ETFs including active ETFs and managed accounts.

McIvor says the managed accounts structure aids innovation and optionality, effectively allowing for a smoother and more tax effective transition through different growth and defensive mixes throughout a client’s lifecycle.

“Plenty of advisers still use diversified managed funds but it’s changing quickly and more are using diversified SMAs for that core exposure,” McIvor says.

To support advisers to build scalable portfolios that meet their clients’ specific needs and objectives, Vanguard recently launched a suite of core-satellite model portfolios, in partnership with Lonsec Investment Solutions (LIS).

The idea came out of Vanguard’s regular portfolio construction workshops.

McIvor says the clear feedback from those sessions was that many advisers wanted ready-made solutions that assisted them with both asset allocation and manager selection.

“Portfolio construction is a really important function as it fuels a client’s strategy, but the question is, who’s ideally positioned to do that work?” he says.   

“While many advisers have the knowledge and skills to build and manage portfolios, there is a widening advice gap in Australia, and we need to find ways to enable advisers to spend more time in front of clients.”

“Advisers are increasingly looking to outsource non-core functions to specialists so they can focus on helping clients understand and go after what’s truly important to them, and work on higher-value activities such astax planning and structuring.”

Adviser’s alpha

McIvor points to recent research by Vanguard on adviser alpha, which claims that using an adviser adds around 3 per cent per annum in net returns over the long-term.

Interestingly, those gains are not necessarily from outperforming the market but rather are driven by a range of factors including behavioural coaching, putting the right tax-effective structures in place, and support sticking to a long-term financial plan.

“Our research has found that improving performance depends largely on relationship management, particularly building client trust rather than portfolio management,” McIvor says.

“That said, relationship management takes time and commitment, which requires advice businesses to streamline some aspects of their practice and reallocate the time saved to seeing clients.”

 McIvor links the rise of asset consultants in the past five years to the growing acceptance and popularity of managed accounts.

“Many advisers don’t want to be making investment decisions every day, and they like managed accounts and the efficiencies they can deliver,” he says. 

“Managed accounts are ideally suited to advice businesses looking to outsource more investment functions because, as a structure, it lends itself to professional management.”

The perfect number

When it comes to determining the number and type of funds that should make up the core and satellite components of a portfolio, there are no hard and fast rules.

Advised portfolios generally hold two to three satellites per sleeve, which McIvor describes as “reasonable”. However, some hold more.

Satellite funds are also typically actively managed, which McIvor says highlights how far the active-versus-passive debate has come.

“We don’t see a lot of investors who are completely passive or completely active,” McIvor says.

“What we are seeing is a greater focus on fees and a shift to low-cost strategies. Obviously, if you’re paying less, your ability to outperform is higher because fees aren’t eating into returns and we believe that the market will continue to compress, which is great for investors and advisers because they can access high-quality investment management at a lower price.”