Core and Satellite Portfolio Investing: Does it make any sense?

Every few years, especially after an asset class has made sudden, sharp gains, the idea of Core and Satellite Portfolio Investing comes back into vogue (see also here). The idea itself is straightforward. Put the majority of your assets (say 50% to 90%) into a low cost, passive index investment, and have a satellite portfolio portfolio of a few concentrated bets which can pay off well in the future. These concentrated bets have changed according to the latest fads. So, gold, emerging markets, China, commodities, hedge funds, private equity, venture capital, and maybe ESG, crypto and meme stocks now – all have had their time in the sun. But does this actually work out for the investor in the long run? Does Core and Satellite Portfolio Investing make any sense? Or could it be the moonshot investment approach which we are all looking for?

Is Core and Satellite Portfolio Investing the moonshot we are looking for?

How does Core and Satellite Portfolio Investing Work?

As the term suggests, Core and Satellite Portfolio Investing breaks your overall portfolio into two parts. The core portfolio typically comprises broadly diversified holdings representing your strategic asset allocation for the long term. The satellite portfolio comprises investments into a specific market, sector or theme, and so warrants a smaller allocation relative to the core portfolio. This is because satellite portfolio investments are typically higher risk. A China technology fund, for example, may be very concentrated.

So far, there isn’t any consensus on how much weight is to be given to the satellite portfolio. Recommendations of between 10% to 50% are common, but the idea is that it should be small, as Vanguard illustrates below:

Illustration of the Core and Satellite Portfolios

Core nd Satellite Portfolios Vanguard — Source: **Vanguard**

But the advocates of Core and Satellite Portfolio Investing are quick to stress its advantages:

A core-satellite approach to constructing an investment portfolio is one of the ways to build a diversified portfolio at relatively low costs compared to individual stock picking. Investors are able to get consistent returns from the core of the portfolio while positioning themselves for better-than-average returns with the satellites.
– DBS

A core-satellite approach is an effective yet interesting way of building wealth over the long term. You benefit from the steady market returns generated from your core investments while enjoying the thrill of your satellites outperforming the market from time to time. In fact, it’s a win-win-win. Better diversification, low fees and the potential for higher risk-adjusted returns.
– Syfe

Does Core and Satellite Portfolio Investing Actually Work?

But does Core and Satellite Portfolio Investing work? Is there any evidence to show that it outperforms a passive approach to investing in index funds? Or is there any theory behind why it does better? Or it is simply marketing spiel?

Let’s see if we can come up with a scientific answer to this question. The idea of passive investing is to maximise returns by minimising buying and selling of assets. Index investing is one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon. This is because market index portfolios are usually considered efficient portfolios, as they contain a broad variety of assets, and generally represent the highest returns that can be achieved for a given level of risk. The core portfolio in the Core and Satellite approach are usually built on efficient market index portfolios.

But the satellite portfolios are a different story. As described earlier, these are concentrated portfolios of assets in specific markets, sectors or themes. Hence they are unlikely to be efficient portfolios themselves. Does a combination of an efficient core portfolio and an inefficient satellite portfolio result in a better outcome in the long run?

Suppose we have two risky assets (in this example, the S&P 500 ETF SPY and the Nasdaq 100 ETF QQQ) and a relatively safe one (here, the Barclays Aggregate Bond Index ETF AGG). We can form two efficient frontiers using combinations of either of the two risky assets with the safe one, as we show below.

Efficient frontiers using combinations of SPY and AGG, and QQQ and AGG (2003-2021)

From the chart above, we see that one of the efficient frontiers dominates the other, in that any combination of the risky asset with the safe asset has a return and/or lower volatility than combinations of the other risky asset and the safe one. Now, what happens when we combine the portfolios on the efficient frontier (the core portfolio) with the portfolios on the lower line (the satellite portfolio)? This is what we show in the chart below.

Expected Risk and Return of Core-Satellite Portfolio Combinations

Core and Satellite Portfolios compared to Efficient Frontier

The core-satellite portfolios formed by combining an efficient portfolio with an asset which is within the efficient frontier leads to the overall core-satellite portfolio combination being inefficient overall. The only case where a core-satellite portfolio combination does better than the original efficient portfolio is when the satellite portfolio:

Also sits on the efficient frontier. i.e. it is also part of the efficient portfolio
Sits higher then the efficient frontier. i.e. it has a higher return for the same level of risk as the efficient frontier

In the first case, there is no need to consider Core and Satellite Portfolio Investing at all, since both the core and satellite portfolios are part of the same portfolio anyway. The second case should not be possible, unless the passive core portfolio is not properly structured using low cost market indices in the first place.

Therefore, the conclusion is that Core and Satellite Portfolio Investing will invariably lead to poorer investment outcomes over the long term. Which is also why there is no rigourous theoretical support for such an approach to investing in finance theory. In other words, it is mostly marketing spiel rather than something which is beneficial for the investor!

Adding satellite portfolios will only make your overall portfolio returns lower and risk higher in the long run

Why is Core and Satellite Portfolio Investing still popular if it makes us worse off?

Since there is no added value in having a satellite portfolio if the core portfolio is already an efficient portfolio, why do we still do it? It could be because we are all irrational to some extent, but even if Core and Satellite Portfolio Investing is pure marketing spiel, there must be something which appeals to us. And if institutional investor do it too, surely they are less likely to be irrational like the rest of us!

One possible reason, as Meir Statman (2017) writes in his magisterial tome on behavioural finance, is because we do not just invest for higher returns and lower risk only i.e. utilitarian benefits. We also invest for expressive and emotional benefits, and these could be related to social status, pride, values etc. Or in other words, FOMO and YOLO as well. Just imagine seeing our friends and colleagues making money hand over fist in crypto, meme stocks, commodities, China stocks etc. Even if we are convinced that these are mere gambles and not worthwhile long term investments, we might still want to put a little of our money into these alternative investments as part of a satellite portfolio. Just so as to have the bragging rights about being “in on the latest fad investment” should they turn out to be winners.

But while this is a logical answer, it is not complete. And it does not answer the question why some people put more into these satellite portfolios than others? To the extent that we are sometimes warned not to go overboard with satellite investing, so as not to end up with a Satellite-Satellite portfolio, which is composed of many different alternative investments, but no core, long term, low cost, passive investment.

So then, who is right? The ones who proclaim they are “All in crypto!”, or the ones who advise putting no more than 5% “play money” into these alternatives?

What determines the optimal size of the Satellite Portfolio?

Interestingly, this is something behavioural finance, the more correct basis of all personal finance, has more to tell us about. Unlike traditional finance theory, which will simply dismiss Core and Satellite Portfolio Investing as being irrational. Let’s illustrate this using another example from Statman (2017).

Suppose you now have the choice of only two investments:

A stable, long term investment, with an expected return of 10% and a volatility of 15% per year
An alternative “investment”, with an expected return of 0%, but a volatility of 65%. Which means it could shoot for the moon, or crash valueless in the near term
Both these investments are uncorrelated with each other

These two choices are shown in the chart below:

A stable investment or an alternative investment?

If we look at the choice of these two investments in terms of expected return and volatility, there is absolutely no chance that we will ever select to have even a little bit of the alternative investment in our portfolio. As we prefer higher returns and lower risk, we prefer portfolios towards to upper left of the chart below, which is 100% in the stable investment.

Rational choice between a stable and an alternative investment

Stable vs alternative investment in returns-risk space

Yes, although putting 5% of our money in the alternative investment can lower the volatility of the portfolio ever so slightly, it is not worth our while to do so because it also lowers return by more. So rationally, nobody will put even a cent into alternative investments.

But often, our rationality is bounded, in that we cannot see very far into the future. And hence we may not really full grasp what long term returns and volatility does to our investments. What we do know is that in the short term, we have wealth targets to reach. For example, we may have $100,000 to put into investments between the stable and the alternative investments. And in a year’s time, we may hope to have $125,000 in order to make a down payment on our dream apartment.

When we think in terms of wealth targets, our perspective on investments changes. Sticking everything into the stable investment will likely get us to $110,000 in a year’s time, but there is almost no chance of having $125,000. Putting everything into the alternative investment actually gives us a better chance of getting $125,000 … or ending up with far less. But it may a gamble we are willing to take to get us to our wealth target.

Putting everything into the alternative investment gives us a better shot at reaching our target wealth of $125,000. (Preference is for portfolios to the left of the chart)

High risk investments to reach target wealth

Being rational and putting everything into the stable investment (or even having 5% – 10% in the alternative investment) will leave us with a greater than 80% chance of missing our wealth target of $125,000. But putting everything into a crazy gamble of the alternative investment will only have a 65% chance of missing our wealth target. So let’s go all in to crypto, or meme stocks, or whatever is the flavour of the day!

But wait! There is more! If we set our wealth target lower, say at $115,000 instead, our perspective changes again. The nearer we are to reaching our wealth target, the less we will put into the alternative investment. In fact, if our wealth target were to be $110,000, or $105,000, which will almost certainly be achieved with just the stable investment alone, we will put hardly anything into the alternative investment, as we show below:

The amount we put into the satellite portfolio depends on how far away our wealth target is

HOw much to put into the satellite portfolio

When our wealth target is very close and easily achievable (e.g. $105,000), we may be willing to put just a little into the satellite portfolio of alternative investments “just for fun”, because it hardly affects the likelihood of reaching our target. Or we could just stick with the stable investment and forget about the stress. Either way, it means that the wealthy are either all in the core portfolio only, or have a very small allocation to the satellite. Those who are not yet wealthy will be far more willing to take the chance of the gamble to be wealthy overnight.

Which probably explains why the people urging everyone to go “all in” to crypto, meme stocks, China etc etc., are generally youngish and still far from their dreams of wealth. Whereas the billionaires and multimillionaires prefer to play it safe by keeping most of their wealth in stable investments. And maybe just a bit on the side for the bragging rights if these alternatives rocket. And it also explains why the newly minted wealthy from crypto and meme stocks and even China tech stocks are looking to move their wealth to safer stores of value. Like property for instance.

Conclusions: Does Core and Satellite Portfolio Investing make any sense?

While Core and Satellite Portfolio Investing is popular, there is no rational financial theory that lends any support to it! But what traditional financial theory cannot explain, behavioural finance theory can, and does not simply dismiss it as being irrational. We invest for more than just utilitarian financial returns versus risk reasons, and other aspects of investing, such as the need to belong to the exclusive social group of investors in certain assets, or the bragging rights of being one of the elite few to spot a high growth investment, or simply just the fear of missing out, can be just as important.

Behavioural finance goes beyond just this to also explain why the choice of investing in a satellite portfolio also depends on how far away our wealth target are, and also predicts that the wealthier investors will not put more than a very small proportion of their wealth in such satellite portfolios, while the less wealthy are more likely to bet everything they have on such satellite portfolios.

Whether you believe in Core and Satellite Portfolio Investing, and how much to put into it, depends on how wealthy you are, and how much more wealth you want to have