Chris Rule: Unpacking Core/Satellite – best portfolio strategy for private investors

In this special podcast, Chris Rule explains the Core/Satellite portfolio strategy approach which is becoming increasingly popular among private investors worldwide. Core/satellite is an approach Biznews endorses – as you’ll see from our Global Share Portfolio where 30% is held in the core and the balance in stock picks. Chris unpacks how the Core/Satellite approach works, explaining why it makes so much sense.  We agree. – Alec Hogg 

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This special podcast is brought to you by Coreshares…that’s the new name of what was Grindrod ETFs?

That’s correct, Alec.  We’ve decided to brand Coreshares independently of Grindrod, although they’re still our shareholder.  That was really, to bring a fresh perspective into the market.  We embrace the Core/Satellites investing philosophy – using passive at the core of your portfolio was the inspiration behind the Coreshares brand – to embrace this core and satellite investing philosophy.

Did you bring it pick it up from somewhere else?

There’s a lot of research around core/satellite investing, specifically in the United States.  There’s a lot of talk around positioning your portfolio using a core/satellite approach, so we’ve been doing a lot of reading and a lot of research around the US and the European markets, which are significantly ahead of us in terms of the progression of their passive and their ETF market.  We drew inspiration from holding passive at the core of one’s portfolio and selecting active managers around that.  To embrace that and to try to filter it through our brand, we selected Coreshares as the brand name.

Many people think of ETF’s as ‘index tracking funds’ but they can be much more.

Absolutely.  The way the index world has progressed over the last 10 years is that they’ve moved away from your very vanilla index tracking (i.e. Top 40 tracking funds) into specific niche asset classes, where you can get specific exposure into commodities.  Now the trend is moving into Smart Beta or alternative indexing, which picks certain factors and fundamental underpins, and tries to put that in a rules based index format.

Getting back to core/satellite.  How big is the core?

The core depends on the investor, essentially.  Naturally, the core would suggest that it’s more than 50 percent of one’s portfolio, but how far beyond that is really up to you.  For example, many pension funds and institutional investors are using a passive core of up to 70/75 percent of their portfolio, but it really comes down to is your conviction around your satellites.  Do you have an asset manager whom you can select where you are absolutely convinced that he will outperform a given benchmark?  If so, you may want to increase your satellite weighting.  However, if you feel that asset allocation within passive building blocks is your value add. then naturally your core would be larger and closer to that 70 percent.

A very strong argument is being used now, particularly in the US but also, even in South Africa that you can put 100 percent of your equity investment, into a Tracker Fund – into an ETF.  I guess that what we’re talking here is that it can be anywhere from zero for active managers, which means you just put it all into your ETF, to 100 percent for active managers and then you have no ETF.  Typically, though, (internationally) what is the breakdown?

Typically, you’re looking at around 60/40.

Sixty percent in ETF’s?

Sixty percent in a passive product and 40 percent in your satellites.  Really, we absolutely accept there are active managers that will outperform benchmarks over periods of time.  What we’re saying is that it’s very difficult to consistently select – in advance – those assets managers who will outperform going forward.  For that reason, it’s prudent to hold a vast proportion of your portfolio in passive products, which are low cost, give you broad diversification, and are very accurate at tracking a benchmark.  In other words, they’re predictable in terms of the benchmark they’d track.

What about private investors?  Are you seeing that they would also apply a Core Satellite approach, i.e. an Index Tracker taking half of my portfolio and individual shares for the others?

From a private investor who’s simply stock picking on the market and has 10 or 20 shares; again, that is a very prudent investment philosophy.  Interestingly, it’s not one that’s going to diminish your returns.  From a risk-adjusted return perspective, to hold the core of 50 percent ETF’s and then you enjoy stock picking, to then select 50 percent in your high conviction stock picks, makes a lot of sense because you significantly minimise the risk at an overall portfolio level whilst not diminishing your returns.

Why is it that South Africa has taken so long to click to the attraction of Exchange Traded Funds?

I think the South African market is slightly behind insofar as unit trusts have dominated our markets.  If you look at the how the asset management market progressed, it moved from where the big life insurers were selling life products and insurance products, into starting to move into selling unit trusts.  In the discretionary space, many of those unit trusts were distributed via the Independent Financial Advisors (IFA’s) who sell unit trusts, and they sold them via platforms called LISPs, which is a Linked Investor Services Platform.  At present, ETFs aren’t available on many of those LISPs.  In terms of the discretionary distribution of ETFs through the IFA market, it’s been very thing.  What we are seeing now is pick from those retail investors that you speak about who have a Standard Bank Online Portfolio with 20 shares.  They are showing a lot of interest in ETFs, which is very encouraging.  Really, it’s education and getting the news to these investors that these products are available and this is what they’re all about and they aren’t simply, just a cop-out to say, “Well, I’ll just buy this index because it’s easier than selecting shares”.  The research will show (over any given period) that the majority of investors who are stock selecting will underperform those indexes.  I think it’s really, an educational story.

I guess also for financial advisors themselves, as they move more and more to a fee-based model, they don’t have to worry about the higher commissions that they would be earning in life policies and unit trust, and low commissions in ETFs.  They’d be bundling the most efficient investment products for their clients.  That must be a big opportunity.

Absolutely.  We see our phase in the financial advisor market as absolutely, vitally important within our space insofar as that their advice process is as important as anything else in the chain is.  Selecting an ETF/index is a very difficult thing to do, so their advice is important.Rather than squeezing their fee – which we think is justified – rather look at the product level where you can decrease the fee.

The fee on ETFs is much lower, though.

Yes.  The cost on ETFs is much lower.  In fact, National Treasury summarised it in one of their most recent papers where they said, passive investing is not demonstratively inferior, but is significantly cheaper than active management.  I think that really sums it up in that you’re getting a very similar product at a much lower cost and the advice process is still important.  That hasn’t changed.

You guys have five JSE listed ETFs at the moment, within Coreshares.  Another two are coming if the Nedbank relationship goes through.  Just explain how that works.

We have entered into an amalgamation agreement with Nedbank, subject to FSB approval. It means that the current unit holders or the ETF shareholders of the Nedbank Better Beta products are being balloted.  If it’s a favourable ballot, then those two portfolios will move across to our management company.  We think it’s likely to happen, but subject to the regulatory steps.

Where are they focused?

Nedbank has moved away from the ETF market.  They have a big active business, as you know.  They have the Best of Breeds model where they select active managers….

I meant the ETFs, themselves, that are perhaps going to come into your field.

Nedbank has two ETFs.  One is the Better Beta Top 40 Equal Weighted, which simply takes the Top 40 shares (the Top 40 Index) and rather than giving it a market cap weighting, it equal weights those shares.  What you have is that you decrease that exposure to the typical large caps like Naspers, SABMiller, and BAT etc.  You bring those weightings down and you up-weight the slightly smaller shares.  From a broad diversification perspective, you get a more evenly spread basket of shares.

That could also be part of the Core that we’re talking about here – Core/Satellite.

Absolutely.  A products like a Top 40 Equal Weighted or even a Top 40 or a Top 50 Tracker, which we’ll be launching in the next month or so.

That will be your eighth, if the other two come in?

That’s correct.  That is your typical example of a core where you simply access a very low cost diversified basket of shares, which tracks an index.

For your own family, when they ask you about this Core/Satellite approach…  What do you tell them?  How much would you suggest they put in the core?

Since my family is not the most financially savvy, I would suggest that they put 100 percent in their core.

If you like Allan Gray for instance, and you want to give them a little bit of an outperforming chance, you might put ten percent there?

Correct.  You could put ten percent to 30 percent, particularly if you’re someone who’s interested in the stock market, you have a bit of an itch to scratch, and you want to stock pick.  To hold 70 percent in a core and keep yourself almost as a hobby and pick 30 percent makes a lot of sense.