Build better portfolios with ETFs: a Core and Satellite strategy can improve returns and reduce risk - Exchange Traded Funds

Whenever you can find a strategy that is both simpler and better, it merits attention. Such is the case with the portfolio construction method known as "Core and Satellite."

Before we get into it, we need to make one determination. The first step towards a well-structured portfolio is to determine your strategic (long-term) asset allocation. Your brokerage firm should be able to help you out here as most offer an electronic or paper-based solution that will match your investment needs. You will end up with certain percentages in broad asset classes such as cash, bonds, equities and perhaps some alternative assets such as real estate and precious metals. For most long-term investors, equities will represent the largest and most challenging chunk of the assets. This is where Core and Satellite is the most effective and where we will focus.

Global equity portfolios can be constructed using broad-based national market or regional Exchange Traded Funds (ETFs), with their indexing (passive) investment philosophy, to form the solid center and deliver low-cost, tax efficient and precise performance. Orbiting about are "actively managed" satellites used to enhance performance or reduce risk. In other words, this strategy uses active and passive investment strategies in complementary fashion. This is the same formula employed by some of the largest investment pools of capital in the world, pension funds. In fact, according to research from Charles Schwab and Co. (who refer to and have trademarked their strategy "Core and Explore") three distinct advantages occur using this approach:

1) The risk that market benchmarks such as the S & P/ TSX 60 or the S&P 500 will outperform your portfolio is reduced.

2) The portfolio has a higher potential of beating market benchmarks.

3) The portfolio will likely experience lower volatility versus an all-active portfolio.

If market pundits, including Warren Buffett, are correct in their assertion that equity investors will likely experience single digit returns in the future, a low cost core will be crucial. However, undoubtedly the best feature is that the satellites can be as varied as the number of investors themselves. Possibilities include individual securities, mutual funds, separate accounts, hedge funds, sector ETFs, option-related strategies, income trusts, wrap accounts, etc. And they can be switched or rotated to suit market conditions or personal preferences. The core, on the other hand, tends to stay relatively static save for the periodic rebalancing needed to return to original weightings.

If you want more information on this strategy, Chapter 4 in The New Investment Frontier goes into greater detail and provides examples. Also in that chapter are numerous other ways to use ETFs to boost your investment results. These will be the subjects of upcoming columns.

Howard Atkinson, CFA, CIMA, is author (with D. Green) of The New Investment Frontier: A Guide to Exchange Traded Funds for Canadians. He is also the National iUnits Marketing Manager at Barclays Global Investors Canada, Ltd. Phone 416-594-4404.

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