When it comes to designing core-satellite portfolios, the popularity of the S&P 500 and Russell 3000 indexes may be waning.
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The basic idea behind this investing strategy is to seek to combine the best attributes of passive and active investing into one portfolio.
Passive index funds (the core) offer lower costs, broader diversification, tax efficiency and lower volatility. Actively managed funds (the satellites) are riskier, but offer the potential for market outperformance.
The S&P and Russell indexes are popular with fund managers as passive strategies for two reasons: to buy the market and to supplement active managers in core-satellite portfolios.
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In my view, there’s another, more effective, way to design core-satellite portfolios, offering the potential of higher returns and better diversification.
The original purpose of the core portfolio was a completeness fund, rounding out a team of specialist active managers.
In its simplest form, an active growth stock manager and an active value stock manager are rounded out by a passive core. But the common practice for this core has been wrong in my opinion.
In practice, “core” is always a total market index, namely the S&P 500 or the Russell 3000. This practice dilutes active satellite managers rather than completes them in my view.
The S&P 500 and Russell 3000 indexes are value and growth and core, all wrapped into one. Active managers are paid high fees to pick concentrated portfolios of 20 or 30 superior companies.
Adding in a market index brings in hundreds (S&P) or thousands (Russell) of deadweight stocks that the active managers don’t like, in my opinion. It’s like adding water to a fine 50-year old Scotch, a foolish and expensive mistake.
I think a better choice for core are the stocks that are not in active manager mandates – good companies that are not on active managers’ radar screens.
Most active managers are either value- or growth-oriented and they are scrutinized to stay within their proclaimed specialty. But some stocks just are neither value nor growth — they’re the stuff in the middle between value and growth.
There’s a continuum in styles, running from deep value to aggressive growth, and along the way there’s a collection of “fuzzy” stocks that don’t qualify as value or growth.
There are 45 such stocks in the large U.S. company space. In my opinion, these are great companies that are generally not held by active investment managers.
Core-satellite has been embraced as a way to diversify and lower costs, but the S&P 500 and Russell 3000 indexes as core do neither. They result in an underweight to the middle of the market, so they do not diversify.
And they undermine active manager decisions with deadweight stocks the active managers deem unworthy.
I think this dilution comes at a cost that can easily exceed the “savings” attributed to a passive index, so costs are actually increased rather than decreased.
Centric is the new core that really does improve diversification and performance, in my opinion. Centric core is a disruptive innovation that replaces the S&P 500 and Russell 3000 as core.
In my opinion, the mighty S&P 500 and Russell 3000 indexes are fading away, replaced by disruptive innovations in both of their applications. Smart beta alternatives to market indexes offer the prospect of outperformance.
The centric core alternative to core in core-satellite investing seeks to provide better diversification and higher returns. In my opinion, it’s a smarter beta that delivers smart alpha by getting out of the way of active managers, allowing them to do their jobs.
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