Mix core and satellite to balance your risk

There is no perfect definition for how to use core and satellite investments in a portfolio, but core funds will usually be selected according to an individual's long-term financial goals, while satellite holdings will be selected on the basis of market movements.

Beyond that, there are a number of different approaches to building core and satellite holdings.

Strategies for lower-risk investors

For investors just dipping their toe into investing, possibly without the tools to make an informed judgment on a manager, passive funds can provide a cheap and easy solution. A core holding in a mainstream index is a good place to start building exposure to markets. This might be the FTSE All-Share or international indices such as the FTSE Global.

Investors could also buy a little exposure to commodities such as gold or oil through a natural resources fund, or perhaps exposure to racier markets such as China or Brazil. Another alternative may be to use a multi-manager strategy at the core of a portfolio with passive funds around the edges to lower costs.

Strategies for medium-risk investors

Medium-risk investors might seek out passive funds for the cheap core of their portfolio in efficient markets such as the US or UK. From there, they might wish to add spicier active managers who give a greater chance of outperformance. The alternative would be to focus attention on selecting a few core active managers to hold for the long term and then adding racier, more short-term and tactical holdings - such as emerging markets or commodities - using passive funds.

Whichever route an investor takes, they should always start with an appraisal of risk, which cannot be properly assessed in isolation. A FTSE 100 (UKX) index tracker may be low risk to a 30-year-old, and therefore sit in the core bucket of their portfolio. For an 80-year-old, UK equity may seem extremely high risk and might therefore sit in the satellite bucket.

Find out the basic principles behind, and the characteristics of, core and satellite holdings in: What are core and satellite funds?

Stephen Peters, investment trust analyst at stockbroker Charles Stanley, defines his idea of core and satellite: "The long-term core holdings are those that I'm not going to sell. I may take profits, but they will always be in the portfolio. On the investment trust side, for example, I wouldn't be worrying about whether the discount moved a little this way or that way. The funds in this part of our model portfolios would include the Invesco Perpetual Income & Growth fund, BH Macro and Scottish Mortgage. Our core holdings would always cover a variety of asset classes."

Tactical and opportunistic

Strategies for higher-risk investors

Investors with a higher risk tolerance may have the skill and judgment to find the right active managers for the heart of their portfolio. However, they may use passive investments to take short-term positions in individual markets - if they believe there is going to be a short-term rally in the European markets, for example.

They might also take positions in commodities, betting on the direction of the oil price. Alternatively, they might choose to have exposure to less mainstream assets - hedge funds or more esoteric property funds, for example - at the fringes of their portfolio, rather than disrupt their core holdings.

Peters's satellite positions are tactical and opportunistic. He says: "It might be where a discount on an investment trust has become particularly wide, so we can pick up the assets cheaply. It may be where there are sectors in favour or good long-term opportunities. For example, we hold the BlackRock Frontiers fund in this part of our portfolios. Other satellite funds we hold include the JPM European Smaller Companies fund, the Aberdeen Asian Smaller Companies fund and the Artemis Alpha fund."

Gavin Haynes, investment director at discretionary stockbroker Whitechurch Securities, puts the core of his portfolio with active managers that have consistently beaten the index without taking too much risk. He says: "If we can't find a manager to do that, we will take a low-cost passive approach to access an individual market." However, he says this only tends to happen in the difficult-to-beat US markets.

Haynes's satellite holdings are managed on a more tactical basis, looking to take advantage of style-specific movements in markets. "We might move between large and small or sector-biased funds. We look to our satellite holdings to be taking on more risk in the market, and we want to see a high-conviction approach. We are also much more short-term and active - we would tend to be looking on a 12-month view."

The approach, the blend of active and passive, and the type of assets included will vary from individual to individual. But constructing a portfolio in this way ensures investors' long-term goals are not compromised by short-term bets on market direction and that the long-term plan does not prevent investors backing their judgment in tactical terms.