The benefits of core-satellite investing

The benefits of core-satellite investing

Contents 1 Core-satellite: A powerful investment approach 3 The key benefits of indexing the portfolio s core 6 Core-satellite methodology

Core-satellite: A powerful investment approach The core-satellite concept is a portfolio construction philosophy that combines the best of portfolio theory and a real-world market-tested approach. In essence, core-satellite is a common sense investment approach that combines the benefits of index funds and ETFs lower cost, broader diversification, tax efficiency 1 and lower volatility with actively managed funds or other direct investments offering potential for outperformance. Core-satellite brings greater discipline and stability to an investment portfolio by: Reducing reliance on picking winning investments or chasing fund manager returns Providing greater portfolio diversification Potentially improving after-tax returns by taking maximum advantage of capital gains discounts Building on the fundamental importance of asset allocation Core-satellite recognizes the fundamental importance of asset allocation for long-term portfolio results. Market timing and security selection may provide some short-term gains at times, but over the long term research has consistently concluded that asset allocation is by far the greatest determinant of portfolio outcomes. As Figure 1 shows, the Brinson, Hood and Beebower paper Determinants of Portfolio Performance (1986) concludes that asset allocation accounts for 94% of the variation in returns in a portfolio, with market timing and security selection accounting for only 6%.. Reducing overall fund management and transaction costs Figure 1: Asset allocation is the most important determinant of a portfolio s return Market timing 2% Portfolio design Asset allocation 94% Objective: Superior long-term performance Security selection 4% 1 Through lower portfolio turnover. 1

Combining the benefits of index and active management The core-satellite concept recognizes the fundamental differences between index and active fund management and combines the best aspects of both approaches. The index approach The primary aim for an index fund or ETF is to track market performance (beta) at a low cost to investors. Index funds achieve this by holding a broad spread of securities within an index with the aim of tracking the index s performance. An index fund or ETF doesn t require the same level of research and security analysis that active management requires (at substantial cost) and will tend to buy and hold these securities with very low levels of portfolio turnover. Lower portfolio turnover results in lower fees to investors and generally more favourable tax outcomes. The active approach The primary aim of an active fund is to seek outperformance of the index (alpha) through security selection and/or market timing. Active funds often hold a smaller number of securities than index funds. Active funds require more initial and ongoing analysis and rely more heavily on the skill of portfolio managers to pick the right stocks. As the name suggests, active funds tend to transact more often, resulting in higher portfolio turnover, which may lead to higher realized tax gains and higher costs to investors in the pursuit of expected returns. The core-satellite approach Core-satellite delivers the best of both worlds. Using index funds or ETFs as the portfolio s core, indexing gives investors a low-cost, more tax-efficient and diversified portfolio, while carefully selected lowly correlated actively managed satellites can complement the core with the potential to outperform the market. Figure 2 illustrates the core-satellite approach. Figure 2: The core-satellite approach Active approach Seeks to outperform Higher cost Higher manager risk Shorter term focus Lower potential tax efficiency Core-satellite approach Combines the best of both worlds Index core Active satellites Index approach Seeks market returns Lower cost Lower manager risk Long-term focus Higher potential tax efficiency 2

The key benefits of indexing the portfolio s core Low costs Indexing has a cost advantage because of lower management fees and transaction costs. Index funds in Canada cost about half the industry average cost of active funds. 2 Management fees. Index funds have lower ongoing fees than most active funds investing in similar assets. In other words, it costs less to manage and operate an index fund or ETF than an actively managed fund. Transaction costs. Index funds and ETFs generally have lower portfolio turnover than most active funds, resulting in lower ongoing trading costs. Tax efficiency Funds with a high level of portfolio turnover generally create greater capital-gains tax liabilities for investors than funds with low turnover. Generally, the lower the portfolio turnover, the more tax efficient the portfolio will be. Index funds tend to have low portfolio turnover because they follow a buy-and-hold strategy. This strategy reduces realized capital gains on which tax is payable, and thus maximizes the compounding effect of investing. Competitive long-term performance Indexing has historically delivered competitive long-term performance at low cost. 3 Historically, few active managers have been able to sustain consistent above-index returns after costs and taxes over the long term. Portfolio diversification Indexing naturally gives investors a well-diversified portfolio through a broad spread of investments within an index. Broad portfolio diversification means less exposure to the performance fluctuations of individual shares or securities. The overall effect is to moderate the volatility of a portfolio and smooth out investment returns over time. Index funds invest in a wide selection of securities in the relevant index, thereby minimizing stock-specific risk. Reduced key-person risk Index funds are more process dependent than actively managed funds, which rely more heavily on the skill of portfolio managers. By reducing the dependence on key individuals, indexed funds and ETFs deliver a greater likelihood of ongoing outcomes and greater stability of results. 2 Source: Morningstar research. 3 Past performance is not an indicator of future performance. 3

Beating the index is challenging year after year Active managers can at times beat the index, but very few beat it consistently. Investors face a major challenge in picking with confidence which managers will outperform the index, let alone when they ll do it. Figure 3 shows the results for Canadian investors in actively managed Canadian equity funds. Less than one-quarter of the top funds (34 of 153) remained in the top 20% of all funds over the subsequent five-year period. Meanwhile, an investor selecting a fund from the top 20% of all funds in 2011 stood a 48% chance of falling into the bottom 40% of all funds or seeing the fund disappear along the way. Stated another way, of the 769 funds available to invest in 2011, only 34 (4.4%) achieved top-quintile excess returns over both the five years ended 2011 and the five years ended 2016. The subsequent performance of those funds in the bottom quintile in 2011 is also interesting: 33% were liquidated or merged by 2016, while an additional 23% remained in the bottom quintile. About 15% of the worst funds managed to rebound into the top two quintiles in the second five-year period. Tax efficiency and the effects of portfolio turnover Taxes can be the largest cost any investor must pay, and can significantly reduce overall net investment returns. Income generated from actively managed funds comes in two forms. The first is made up of dividend distributions from the underlying shares, which may have imputation tax credits or foreign tax offsets attached. This type of income is generally tax efficient. The second source of income is in the form of capital gains distributions after shares within the fund have been sold and the proceeds distributed to investors. Capital gains distributions are either fully taxable or taxed when paid out to the investor, depending on how long the shares sold have been held within the fund. Trading activity or high portfolio turnover can significantly affect after-tax results. Index ETFs by their nature tend to have lower portfolio turnover because they generally hold shares for longer time periods to match the underlying index. Generally, funds with high levels of turnover that is, with shares held for less than 12 months will be less tax efficient than funds with low portfolio turnover. Figure 3: Analyzing persistence of ranking in actively managed Canadian funds Excess return rank 5-year ending December 2011 Highest quintile High Medium Low Quintile rank in subsequent non-overlapping 5-year period (% of funds) ending December 2016 Lowest quintile Closed/ merged Total Highest quintile (1) 22.2% 18.3% 11.8% 9.8% 24.2% 13.7% 100% High (2) 16.8% 14.8% 16.8% 28.4% 11.0% 12.3% 100% Medium (3) 26.1% 18.3% 15.0% 14.4% 9.2% 17.0% 100% Low (4) 10.5% 20.9% 21.6% 15.7% 13.7% 17.6% 100% Lowest quintile (5) 5.8% 9.0% 16.1% 12.9% 23.2% 32.9% 100% Notes: The first columns rank all active Canadian equity funds within each of the Morningstar-style categories based on their excess returns relative to their stated benchmarks during the period cited. The columns to the right, show how the funds in each quintile performed over the next five years. Sources: Vanguard and Morningstar, Inc. 4

The compounding effect of having more money working for investors rather than paid out as income is a distinct advantage of index funds and ETFs. Winners and losers in the zero-sum game Indexing s low-cost, tax-efficient approach to investing makes the inclusion of index funds and ETFs an efficient and highly suitable investment strategy for constructing the core of an investment portfolio. Leading investment academics borrowed the phrase the zero-sum game to describe the investment performance of market securities. For every winner there must be an equal loser. The zero-sum game suggests that when you consider the effects of costs and taxes on investment returns, active managers and individual investors have a difficult task in outperforming the market. Before-cost distribution of returns Figure 4 represents a typical bell-curve distribution of securities returns. Before-cost market performance is the midpoint 50% of returns are better than the market, and 50% of returns are below the market. This is known as the zero-sum game for every winner there is an equal loser. After-tax and -cost distribution of returns All investments incur costs when assets are purchased or sold. When only costs are taken into account, the distribution bell curve moves to the left of the midpoint on the chart. The chance of outperforming after costs becomes more difficult. Minimizing costs gives your portfolio a clear advantage. When both taxes and costs are taken into account, the bell curve moves even further to the left. The challenge to outperform the market after costs and taxes becomes even more difficult. Funds and ETFs that minimize management costs and optimize tax efficiency offer a distinct advantage. Figure 4: The effects of costs and taxes on market returns Costs shift the investor s actual return distribution Underperforming assets Market benchmark Costs Outperforming assets High-cost investment Low-cost investment Notes: For illustrative purposes only. This illustration does not represent the return on any particular investment. Source: Vanguard. 5

Core-satellite methodology The conventional view Conventional wisdom suggests that indexing works best in the market s most efficient segments and that active management works best in inefficient market segments. Such an approach assumes that information is readily available in the most efficient markets, thus allowing market participants to price securities effectively and offering them little opportunity to outperform. Figure 5: Traditional view of core-satellite portfolio construction based on degree of market efficiency Satellite Canada small-cap Satellite Emerging markets On the other hand, it is further assumed that information is less readily available in inefficient markets and that, as a result, individual managers have greater opportunities to outperform market benchmarks. These assumptions lead many advisors to conclude that the relatively more efficient large-capitalization portions of their clients portfolios should be indexed, while the less-efficient market segments, such as small-cap or emerging markets, are better served with active strategies (see Figure 5). Source: Vanguard. Satellite Ex Canada small-cap Core Canada large-cap Ex Canada large-cap 6

An alternative view Vanguard subscribes to an alternative view of the core-satellite framework. We believe that the active vs. index decision should be based on an advisor s ability to identify low-cost, expert managers, rather than on the assumed efficiency of the market segments. Although indexing has historically outperformed active management in the aggregate over the long run, some active managers may outperform in all market segments. As Figure 6 illustrates, regardless of the market segment, talented managers with reasonable costs are by definition more likely to add value to a portfolio than active managers selected indiscriminately from a presumably inefficient market. Figure 6: Alternative view of core-satellite portfolio construction based on manager skill level Satellite Alpha strategies from successful managers Core Beta exposure to broad markets Satellite Alpha strategies from successful managers Satellite Alpha strategies from successful managers Source: Vanguard. 7

Implementing a core-satellite approach The principle of core-satellite can be integrated easily into the traditional process of building an investment portfolio. Risk profiling and asset allocation Risk profile analysis is the first step in portfolio construction. An investor s financial goals, personal situation, time horizon and risk tolerance all need to be considered to build his or her risk profile then matched to an appropriate asset allocation across equity, fixed income, cash and other assets. Canadian equity International equity Fixed income Cash Determine asset allocation The core-satellite index/active balance Within each asset class, decisions need to be made around the proportion of core to be allocated to indexing and the proportion to active management or individual securities. This depends on the level of risk that an investor is prepared to take on, and the level of tax efficiency an investor desires. The mix of index and active chosen may vary from sector to sector. In some asset classes where the indexing case is particularly strong for example, fixed income it may be appropriate to have 100% indexed. Canadian equity International equity Fixed income Cash Allocate index and active proportions Manager selection Finally, you need to decide on an index-fund manager for the core (not all passive fund managers are the same), as well as the number of active managers for satellites chosen to complement the core. Ideally, managers selected should correlate differently to the index core. In some sectors, you may require only one or two managers; in other sectors, you may require more. Canadian equity International equity Fixed income Cash Actively managed funds/individual securities Select index-fund manager and loosely correlated active managers Index-fund investments Note: Asset allocation depicted is for illustration purposes only and is not a recommendation. 8

Conclusion The basic tenet of core-satellite methodology is that investors should choose a strategic asset allocation commensurate with their investment objectives, then select actively managed funds as appropriate to add positive alpha to the baseline portfolio. The conventional view of core-satellite methodology suggests that it s prudent to use index funds for markets that are deemed efficient and to use actively managed funds in areas considered to be inefficient, where active managers are presumed more likely to succeed. At Vanguard, we hold an alternative view. We believe that indexing is a powerful investment strategy in all market segments. As a result, we propose that the active/index decision should be predicated on an advisor s ability to identify low-cost, talented managers, not on the indiscriminate selection of active managers in apparently inefficient market areas. Skill in selecting managers drives the success of a core-satellite portfolio. 9

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