Unconventional wisdom: The academic case for core-satellite is questionable - here’s why it still works
The academic model behind core-satellite has little in common with the approach most investors take.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: The academic case for core-satellite is questionable - here’s why it still works
In practice, such trifles as contradictions in principle are easily set aside; the faculty of ignoring them makes the practical man.
- Henry Adams
When it comes to investing I’m old school. I tend to dismiss fads and believe that the tried-and-true approaches often work better over the long-term.
But I’m not dogmatic. I think investing passively is a sensible approach. I also think there are other strategies that work like my focus on income.
However, my initial reaction to the increasingly popular core-satellite portfolio construction approach was not positive. I struggled with the inherent inconsistencies.
While my thinking on core-satellite has evolved I think it is worth asking two questions.
Is it rationalising two fundamentally different investing philosophies or is it a sensible framework that leads to long-term success?
And more importantly, does reflecting on the strengths and weaknesses of core-satellite provide lessons for all investors?
The academic origins of core-satellite
Core-satellite calls for constructing a portfolio with two components. There is the core which is generally invested passively and the satellite which is used to try and accomplish some other investor goal – in most cases a higher return.
The academic foundation for core-satellite is the Treynor–Black model which was developed in 1973. The model is designed for investors who believe the market is highly, but not perfectly, efficient which means there are small pockets of mispricing which can be exploited.
The Treynor-Black model was proposed at a time when the efficient market hypothesis was all the rage in academia. It is the definition of Ivory Tower thinking. The first index fund wasn’t even available so there was no practical way to implement the approach.
The Treynor-Black model bears little resemblance to the way most people implement core-satellite. Don’t believe me? Here is how Investopedia describes the satellite portion of Treynor-Black:
In the active portfolio—which is a long/short fund, each security is weighted according to the ratio of its alpha to its unsystematic risk. Unsystematic risk is the industry-specific risk attached to an investment or an inherently unpredictable category of investments. Examples of such risk include a new market competitor who gobbles up market share or a natural disaster that destroys revenue.
The Treynor-Black ratio or appraisal ratio measures the value the security under scrutiny would add to the portfolio, on a risk-adjusted basis. The higher a security’s alpha, the higher the weight assigned to it within the active portion of the portfolio. The more unsystematic risk the stock has, the less weighting it receives.
Whatever the underlying merits are of this academic take on portfolio construction it differs from core-satellite in practice.
Treynor-Black is not advocating for taking a punt with part of a portfolio. Instead, it is calling for a systematic exploitation of small pockets of mispriced securities in a largely fairly valued market.
It may be satisfying to suggest there is an academic foundation to core-satellite. Just as it is satisfying to cite the health benefits of red wine when I open a second bottle. In both cases the evidence is dubious and the application differs from the underpinnings of the justification.
Core-satellite in practice
I’ve come to believe there are advantages to core-satellite.
My foundational investing principle is the investor matters much more than the investments. Better outcomes come from better behaviour.
One of the hallmarks of core-satellite is the flexibility it provides. This flexibility means investors can be thoughtful and measured or impulsive and reckless.
This flexibility also allows investors to express two opposing impulses. To be a successful investor involves suppressing the influence of emotions on decision-making and trying to act as rationally as possible.
To be human means acknowledging that complete rationality is impossible. Nobody can persist with absolute discipline and rationality over the long-term. That is why diets have cheat days, people have mad money and there are no calories on vacation.
The core is evidence based and rational. The satellite acknowledges human nature and serves as an outlet for conviction and the urge to take more control of outcomes.
Countless nausea inducing self-help gurus yammer about the dangers of distractions. But since doing nothing is often the best thing for an investor a limited outlet provides balance. With all the attention on the satellite the core quietly compounds away.
This is why my thinking on core-satellite has evolved. You can be old school but also change your mind. The inconsistencies in the approach mirror human nature.
That doesn’t mean anything goes. The core principles for success apply equally to all portfolios.
Principle one: Have a coherent strategy for your satellite that links to your goals
This is investing 101. If you don’t bother to define a goal you can’t come up with a plan to achieve it. A plan has several components including savings goals and asset allocation targets but it also needs an investment strategy.
Passive investing is a simple but effective strategy. More care needs to be taken with the satellite component. Investing most of your portfolio passively is an acknowledgement of how hard it is to pick the right individual shares.
I personally believe the best use of the satellite component is to use it to tilt your portfolio in a direction aligned with your goals.
The tilt could be towards a particular attribute like quality or income or to serve a purpose like lowering the volatility of your growth investments. It could be to add an equal weighted component to balance whatever theme is dominating market capitalisation weighted indexes – AI being the current example.
You could use the satellite to try and outperform but only if you have a coherent thesis on how you can generate higher returns. More on this later. Just make sure you aren’t flying blind without any structure. That isn’t a recipe for success.
Principle two: Asset allocation matters more than security selection
Asset allocation is the biggest driver of long-term returns. Your overall asset allocation still needs to align with the return you need to achieve your goals.
Core-satellite introduces a new element to asset allocation. There is no rule about how big your satellite should be and I’ve seen advocates for everything from 5% to 20%.
The size of your satellite should reflect the role it plays in your portfolio. A tilt supports a higher allocation while speculation deserves less of an allocation.
For older investors the speculative satellite should be small enough so a significant loss wouldn’t jeopardise your ability to achieve your goal given your remaining investing timeline. For younger investors remember it isn’t what you lose but the opportunity cost of what it could have grown to in the future.
Don’t fall victim to moral licensing where your passive core justifies taking outlandish risks in your satellite. Be wary of the impulse to increase the size of your satellite after strong performance.
Also be careful your satellite doesn’t stealthily take over your portfolio. This tends to happen over time so come up with an approach to rebalancing between the two components.
Principle three: Think about your edge
Many people use their satellite to try and outperform. This is a common and understandable impulse and labeling it as greed or overconfidence is counterproductive.
Once again, investing most of your portfolio passively is an acknowledgement of how hard it is to consistently outperform. Stumbling into high returns is luck. You need a thesis and plan to try and beat the index.
Think about the edge or competitive advantage you have over other investors. Think about why you will succeed when so many investors fail. You won’t get better results if you do what everyone else does.
Is your confidence in your ability to outperform based on knowing more than other investors? Is it drawing better conclusions from widely known information? Is it behaving better than other investors?
Whatever it is, write your edge down and revisit it each time you adjust your satellite.
Final thoughts
The passionate and ideological debates about different approaches mask the universal truth that investing is ultimately an exercise in pragmatism.
Leave the debates on the ‘best’ way to invest to academics. Avoid using theory to justify poor behaviour. Focus on the outcome and acknowledge the obstacles inherent in human nature.
Figure out where you want to go, come up with a plan and give yourself a fighting chance to get there.
Quesitons, comments or restaurant recommendations? I can be reached at [email protected]
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What I’ve been eating
Tom yum from hell is not my favourite name for a restaurant. But I gave it a shot since the name combines one of my favourite Thai soups with a place I’m frequently told to go. Like all good Thai food, Tom Yum is sour, spicy, salty and sweet. Paying the Barangaroo prices for lunch added the missing element of bitterness.
This was a core-satellite approach to Tom Yum. The broth was pure Thailand but everything else was ramen-esque with noodles, chicken meatballs, and an onsen egg. Pragmatism prevailed over culinary purity and the result was a satisfying meal.
