Explain the core and satellite portfolio strategy

A conversation over coffee between two colleagues leads to an interesting explanation of a portfolio building strategy.

Vina: Have you heard of Meena making windfall gains from her small investments? It makes me want to try it too. I felt the exact same thing when cryptos rallied last year. I think it’s a kind of FOMO playing!

Tina: Relax Vina. It’s not like she has the Midas touch when it comes to investing. You can also improve your game by venturing into other asset classes. But be aware of the risk you are taking. I hope you know that every asset class that promises you superior returns also comes with equally superior risks.

Vina: OK! But is there not a way out. I mean, what if you want to generate higher returns than the market, and at the same time contain the risks.

Tina: Have you heard of the Core – Satellite portfolio strategy? It is a strategy that aims to optimize costs, taxes and risks across the portfolio while aiming to maximize returns. Perhaps this approach could help you approach your FOMO.

Vina: I guess the core is the main wallet. But what is the satellite portfolio? Does it keep revolving around the core? Like the Moon around planet Earth?

Tina: No Vina. This strategy works as follows. The core portfolio is made up of funds or other investments that aim to achieve its financial objectives — whether through debt instruments (sovereign or otherwise), funds (ETFs or index funds) and ‘other assets that essentially contribute to reducing costs and long-term volatility. For longer term portfolios, gold can also be part of the core portfolio. The smaller satellite wallet is where you can try your hand at riskier actively managed assets for alpha generation. One can also use his satellite portfolio to save tax by investing in share-linked savings plans or ELSSs. Depending on individual goals and the risk associated with stock selection, direct equity investments may be part of your main or satellite portfolio.

Vina: Why two portfolios? How does this help?

Tina: While the Core helps generate the minimum return required to meet its goals based on its risk appetite, the Satellite Portfolio adds extra spice to those returns. It’s much better than burning your fingers by investing your entire corpus in risky assets, all in the name of looking for alpha.

Vina: Fair point. What is the ratio in which I should divide my portfolio into core and satellite, then?

Tina: While there is no one-size-fits-all approach, most experts advise a 70-80% allocation to the core portfolio. The ideal ratio depends on the type of assets added to your satellite portfolio and the level of risk they would add to your overall portfolio. The idea is to earn the minimum return to achieve your financial goals through investments in your core portfolio. Its satellite investments can range from credit risk funds to thematic or international mutual funds, including direct equity investments. Some also prefer to add alternative investments such as REIT / InvITs, PMS, private equity (including pre-IPOs) and even cryptos to their satellite portfolio. Whichever asset class or classes you choose, losses, if any, should not weigh too much on the overall return of your portfolio.

Vina: Law. Put simply, this strategy seems like a fair way of trying to get the best of both worlds, top returns with a cap on downside risk.

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Don F. Davis

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