The Core & Satellite Approach to the Market of Stocks

Advice to the Advisors

Sheaff Brock Institutional Group | Active vs Passive Investment Strategy | Core and Satellite appraoch

The Core & Satellite Approach to the Market of Stocks

When it comes to advising investors, RIAs must don teachers’ caps. Clients have become comfortable (perhaps in their do-it-yourself years before meeting you) with either a largely passive (index fund) approach to investing or, at the opposite extreme, have become used to populating their portfolios with individual stock picks. Going forward, those clients now look to you for insight. Few discussions have the potential for you to offer them true guidance more than the passive vs. active “debate.”

  1. Active investing attempts to beat a particular benchmark and “outperform the market.” As Investopedia explains, “anomalies and irregularities in the capital markets can be exploited by those with skill and insight.”
  2. Passive investing, by contrast, is an approach based on investing in exactly the same securities, in the same proportions, as an index. Portfolio managers don’t make decisions about which securities to buy and sell, but try to replicate the performance of an index of a broad sector of the market as closely as possible.

Some of the policies and initiatives being instituted by the new administration—notably deregulation and an emphasis on infrastructure—might suggest shifting portfolio proportion in favor of more active investments. In an interview with our SheaffBriefs editor, Sheaff Brock Director Jim Murphy suggested that we might well begin to see less of a correlation between sectors and individual stocks.

Murphy, CFP®, CAIA, believes there’s a place for both approaches to the market, dubbing the combination strategy “Core and Satellite.”

  • “The core” consists of passive investing in asset classes (through indexes) with the goal of maintaining overall market-type returns.
  • “The satellites” are actively managed assets in which the goal is to add Alpha (the managers’ ability to achieve excess returns) to the portfolio.

One concept often invoked in the active/passive debate is Capture Ratio, which reflects how much incremental value is added to a portfolio on both the upside and the downside through active management. Upside capture indicates how much value active management added to performance results on the upside (net of fees). An upside capture rate of more than 100% is preferred, showing an additional increase in portfolio value due to active management. With downside capture, the desired rate is below 100%, showing how active managers, net of fees, were able to avoid portfolio losses suffered by passive investing during periods when the benchmark index was in the red.

As your investors consider whether to take an active or passive approach to investing, the answer might be a Core and Satellite approach, tapping into “the beauty of both.”

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