Refining Core-Satellite Investing
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Thanks in large part to the current crisis, investors are showing renewed interest in portfolio construction, and core-satellite investing is regaining popularity. Both Vanguard and Putnam recently announced the addition of “core” products to their suite of funds.
So why the interest in core? It could be for either of two reasons – hedging or completeness – as I will explain.
Ballast or completeness?
Some view core investing as a hedge against underperformance of active managers; in their minds, core is ballast to keep the investment ship steady. The best core for this purpose is the entire market, like the Wilshire 5000, although the most popular choice is the S&P 500. The goal is to dilute the effect of active managers because the investor lacks confidence in them.
In this context, core is a compromise for those who are on the fence in the active-passive debate. Add some cheap passive core to the expensive active manager mix to simultaneously lower costs and guard against the risk of surprises by reducing the tracking error relative to the broad market. The amount such an investor puts in core is a reflection of the lack of confidence in the active manager roster and structure. The more in core, the more market-like one’s performance will be. Allocation to ballast core is a confidence barometer.
By contrast, the original core idea was to diversify while simultaneously encouraging active managers to give it their best shot. The original core concept emerged from confidence in active managers, rather than concern about their making mistakes, so it was a completeness concept that complemented active value and growth managers by adding what they are not – the absence of value and growth. The absence of value or growth is the stuff in the middle that neither value nor growth managers hold. “Core” in this context means “center.” This provides license for the active managers to be undiversified, concentrating in their areas of expertise. This concept, introduced in the 1980s, gave way to style-based equity specialists and has evolved into an insistence on style purity today. There is a premium placed on adherence to style, and a corresponding necessity to fill in the void left in the middle between value and growth.
Both the hedging and the completeness versions of core improve diversification, but they imply different levels of confidence in active management. In this article, I address the application of core for completeness, which was its original intention.
The word “core” refers to a center, a heart, or a hub, but because it encompasses most of the market, the S&P meets none of these definitions. The good news is that there is an efficient completeness core, and it’s easy to understand why it works best in diversifying portfolios of multiple active managers. The S&P 500 and other broad market surrogates may make good ballast for those who are concerned about their active manager decisions, but we need something more specialized when it comes to completing allocations to real talent. Allocation to completeness core is derived from the overlap among active managers.