What are core and satellite funds?

Cherry Reynard explains the basic principles behind, and the characteristics of, core and satellite fund holdings.

Core holdings

The basics

At the heart of any portfolio should be a collection of investments that provide few surprises. These are not the type of holdings where investors have to watch nervously as their investments fly up and down with every pronouncement from the US Federal Reserve; these are stable long-term holdings designed to ensure their owners don't have to spend their retirement in penury or struggle with the school fees.

Investors will have different requirements for the core of their portfolio depending on their age, wealth and risk tolerance, but in general core holdings will have certain characteristics: they will protect against inflation, be 'buy and hold' in nature, not be excessively volatile, not be high-cost and be thoroughly diversified.

To find out how lower- and higher-risk funds can help build diversified portfolios, read:Mix core and satellite to balance your risk.

Characteristics

Matched to long-term goals. If an investor needs income, it should be generated from within the core. If there is a 20-year time horizon for an investment, the core holdings should reflect that timescale.

Long term. The holdings in this part of a portfolio will remain reasonably static. Investors may take some profits if an asset class has done particularly well, perhaps reinvesting in one that has lagged, but the fundamental shape will stay the same through different market conditions.

Balanced. This is the part of a portfolio that has to help meet long-term financial goals. It should therefore have a balance of different asset classes - bonds, equities, property and alternative investments. It should also have a blend of different regions.

Inflation-protected. This goes hand in hand with a long-term perspective. Investors are unlikely to meet their long-term financial goals if they do not have at least one eye on protecting against inflation. This means looking towards equities, property or other assets that have shown themselves capable of outpacing inflation for at least some of the core holdings.

Lower risk. Excessive volatility can damage a portfolio over time. If an investment loses 50% one year, it needs to gain 100% the next to recover its starting position. It is therefore best to avoid particularly volatile holdings in the core of a portfolio and seek instead managers who can deliver consistently over time.

Lower cost. Again, this is part and parcel of the long-term strategy. High costs can drag on returns over time. Core holdings do not have to be passive, but investors should take into account costs when making their selections.

Satellite holdings

The basics

With satellite holdings investors can introduce more positions. These funds allow investors to take risks and back their judgment without it affecting their long-term financial plans. This is where investors can take a short-term punt on a rise in the gold price via an exchange traded fund, for example, or introduce exposure in higher-volatility areas such as commodities. Or it may be where investors take a view that Africa will be the next highly profitable area for investment.

Six of the world's 10 most rapidly growing economies are in Africa, making the continent ripe for profit hunters. David Prosser surveys the lie of the land in:Unlocking Africa's investment potential.

But one person's core is another person's satellite and there are no hard and fast rules about what constitutes one or the other. Some investors, for example, will use passive funds for the core of their portfolio, believing that low cost is the most important contributor to returns over the long term. Others may use a carefully selected range of active managers who have proven themselves consistent performers over time, using passive funds to take punchier, short-term bets on the direction of the market.

Characteristics

Shorter-term. Positions in the satellite part of a portfolio will generally be held for less than 12 months. The satellite area can be used to take advantage of shorter-term market movements in, for example, equities, bonds or commodities markets.

Higher risk. Satellite holdings will usually be more volatile. Commodities would be a good example. They can provide investors with good returns if they are bought at the right time, but many commodities will see significant peak-to-trough drawdowns at certain points in the market cycle.

More complex. The satellite part of a portfolio is the natural home for more esoteric strategies, such as derivatives-based funds or those based on new and illiquid markets such as those in Africa or the Middle East.

Hedging. Satellite positions can be used for hedging. For example, if an investor believes that the equity market is going to fall very rapidly and their core portfolio is going to lose money, they could employ strategies in their satellite holdings to mitigate those losses.