While creating a portfolio, most people fall into two groups – they either try to beat the market and churn portfolio very frequently to seize market opportunities or are completely passive about their investments. Both approaches have some benefits and some limitations.
While an Active investing approach increases the probability of the investor to get more return than the market, it involves more transactions costs, management cost, and taxes (because short-term capital gains taxes are higher). The passive investing approach, on the other hand, is cheaper because it involved less management cost along with less transaction cost and taxes due to rare churn.
WHAT IS PASSIVE AND ACTIVE INVESTING APPROACH?
One should not confuse passive investment strategy with investing in low-risk securities or keeping the money in fixed deposit.
A passive strategy involved creating a portfolio which closely follows a market benchmark. The portfolio gives slightly less (because of transaction costs and taxes) than the benchmark.
The risk exposure is only systematic risk tied to the market i.e. (beta =1). So, if the market is itself volatile, the risk in your portfolio increases.
An investor can create a passive portfolio by investing in Exchange Traded Funds (ETFs) which involves less management and costs and designed to follow a benchmark.
So, a passive portfolio is better for long-term goals such as retirement.
The active investing approach is about looking for market opportunities which can maximize risk-adjusted return. This approach is generally expensive because it involves more management involvement, more transaction cost and taxes due to frequent buy and sell.
The risk exposure is idiosyncratic and higher than the market risk (beta >1).
The portfolio is created with few securities which are expected to perform well in the short to medium term.
Active investing is fundamentally short term.
A core-Satellite portfolio is built by investing a small percentage (up to 30% or 40%) of a passive portfolio as an active portfolio. The core of the portfolio (60% - 70%) is investments passively and the Satellite part actively to benefit from the market opportunities.
The passive core of the portfolio makes sure that the investor will be able to achieve strategic goals such as retirement or higher education of children with high probability by keeping the risk and costs low.
The active Satellite is designed to add some more return. As the Satellite portion is much smaller, the strategic goals of the investors are not much affected by the higher risk involved in the active investing.
BENEFITS OF CORE-SATELLITE STRATEGY
1. It gives the opportunity to increase overall portfolio return without compromising on the strategic financial goals.
2. It imposes a discipline on the investor by limiting the portion of the portfolio available for active investment and churn. Impatient investors are inclined to change their portfolio frequently which not only costs them higher transaction costs and taxes but also they fail to benefit from the higher return of long-term investments strategies. By imposing a limit on what percentage of the portfolio is available for active bets, the chances of incurring too much transaction costs and capital gains taxes are limited.
3. As the core-Satellite portfolio is primarily a passive portfolio- the management cost is much lower compares to an active fund.