How does the core and satellite investment portfolio approach work?
Most investors follow the asset allocation strategy by diversifying their investment portfolio among equity funds, debt funds, gold, real estate, etc. Within equities, they may have a simple portfolio of a diversified large, mid, and small-cap equity fund. However, from time to time, whenever we see a particular domestic sector, theme, or international markets (US) outperforming, we tend to get tempted to invest there. To overcome this temptation, investors can follow the core and satellite investment portfolio approach. In this article, we will understand this approach and how it works.
What is the core and satellite investment portfolio approach?
The core and satellite investment portfolio approach involves dividing your investment portfolio into two parts in a specified ratio.
The core portfolio constitutes the major portion of the overall investment portfolio. It may involve a simple portfolio of three mutual fund schemes (a diversified large, mid, and small-cap fund). The portfolio is focused on achieving long-term financial goals such as building a fund for a child’s higher education, own retirement fund, etc.
The satellite portfolio constitutes the remaining minor portion of the overall investment portfolio. It may involve investing in sectoral funds, thematic funds, factor-based funds (also known as smart beta funds), international funds, or direct equity stocks. The choice of the investment product may depend on the market situation. The objective is to make a tactical allocation and generate higher returns to boost the overall portfolio returns. But, this tactical allocation usually comes at a higher risk.
For example, an individual may decide to have a 70:30 allocation towards a core and satellite portfolio. In this example, the core portfolio will constitute 70%, and the satellite portfolio will constitute the remaining 30% of the overall investment portfolio. Similarly, some individuals may decide to have a 75:25, 80:20, or any other allocation, based on their risk profile, towards a core and satellite portfolio.
An individual following the 70:30 allocation towards a core and satellite portfolio approach may have an investment portfolio that may look like this.
In the core portfolio, the choice of equity funds can be active or passive funds. For example, an investor who prefers passive funds can include a Nifty 100 index fund (for large-caps), a Nifty Midcap 150 index fund (for mid-caps), and a Nifty Smallcap 250 index fund (for small-caps) as part of their core portfolio.
Composition of core and satellite portfolio
For different investors, the core and satellite portfolio composition may differ. For example:
- For some investors, the core portfolio may comprise index funds, and the satellite portfolio may include active funds.
- For some investors, the core portfolio may comprise large-cap funds, and the satellite portfolio may include mid and small-cap funds.
- For some investors, the core portfolio may comprise diversified active funds based on market capitalisation (a large, mid, and small-cap fund). The satellite portfolio may include sectoral, thematic, international, and smart-beta funds.
Why should you follow the core and satellite investment portfolio approach?
An investor needs to follow a disciplined approach along with asset allocation to achieve long-term financial goals such as building a fund for a child’s higher education or own retirement fund. However, the outperformance of certain sectors, themes, etc., may tempt investors to deviate from their disciplined approach and/or change their asset allocation to invest in these outperforming sectors/themes.
Such a deviation may not be in the investors' best interests and financial goals. This is where the core and satellite portfolio approach can come to the rescue of the investor. The approach helps the investor to have the best of both worlds. The investor can follow a disciplined approach and asset allocation with the core portfolio. With the satellite portfolio, the investor can allocate some money to sectors, themes, etc., that are outperforming without deviating from the core portfolio.
While the core portfolio will continue to be unaffected, the satellite portfolio can be churned as per market opportunities. An investor can transfer excess profits from the satellite portfolio to the core portfolio. However, the investor should not do the other way round, i.e. money should not flow from the core portfolio to the satellite portfolio. As long as the satellite portfolio allocation is below a specified limit, its underperformance will not impact the achievement of long-term financial goals.
How to construct a core and satellite portfolio approach based on the risk profile
An investor following this approach may decide the allocation toward core and satellite portfolios based on their risk profile. They may follow a two-step strategy:
- Decide the broad asset allocation towards different asset classes such as equity funds, debt funds, gold, etc. at an overall investment portfolio level.
- The equity allocation may then be split between the core and satellite portfolio.
Based on the investor’s risk profile, the core and satellite portfolio allocation may look something like this:
- Aggressive investor: Core portfolio allocation at 60-70% and satellite portfolio allocation at 30-40%
- Moderate investor: Core portfolio allocation at 70-80% and satellite portfolio allocation at 20-30%
- Conservative investor: Core portfolio allocation at 80-90% and satellite portfolio allocation at 10-20%
Please note that the above are just thumb rules for guidance on deciding on a core and satellite portfolio based on risk profile.
Should you follow the core and satellite portfolio approach?
As an investor, if you do get tempted to deviate from your asset allocation to chase market opportunities, you should adopt the core and satellite portfolio approach. The core portfolio allows you to follow your asset allocation without deviating from it. At the same time, the satellite portfolio allows you to allocate some money to other market opportunities and benefit from them. In short, the core and satellite portfolio approach allows you to have the best of both worlds, so you may consider following it.
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In this article, we learned about the core and satellite investment portfolio approach, how they work, and whether they are a good idea. You can partner with the Glide Invest App for your financial planning journey to get recommendations for the appropriate mutual fund schemes based on your risk profile. You will get advice on planning and systematically investing towards your financial goals.
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