Create a core portfolio to achieve your long-term financial goals and use the satellite portfolio to manage risks efficiently
THE recent volatility in the equity market has forced many investors to look beyond Indian equities. The S&P CNX Nifty rode on the liquidity-driven sentiment to hit a high of 6338 on November 5, 2010. But with domestic issues such as inflation, scams and rising interest rates hitting sentiment, Nifty has lost around 10% from its recent high. No wonder, everyone is looking for investment options. That search brings us to the core and satellite approach to investing.
The Core...:
Here investors construct portfolios for long-term financial goals. The asset allocation may vary, but they have some core holdings in their portfolios. A core portfolio typically comprises diversified assets of high quality and is expected to deliver over a long period of time. This can include blue-chip stocks, highly rated bonds and gold.
Some investors prefer to go with mutual funds that invest in these asset classes. You can have a core portfolio comprising funds such as HDFC Equity Fund, HDFC Top 200 Fund, as they have a very sound long-term track record. The instruments that appear in the portfolio need not be the best-performing instruments in the last quarter, but they would have demonstrated their ability to deliver returns that match those of the market but with lesser risk.
The core portfolio should occupy 80-90% of the total investible money and should be designed to deliver over the long term. Of course, you can increase the weights of certain instruments in the core portfolio if you are upbeat on those instruments for a short period of time. In the long run, the success of the core portfolio is a function of the right-asset rebalancing decision.
& The Satellite:
But there are investors who are also keen on higher risk-adjusted returns and look for short-term opportunities. This is what inspires the concept of satellite portfolio. It is a small portfolio, say 10-20% of the total investible money which is used to tap the short-term opportunities in the market. The portfolio is expected to bring in the much required alpha – excess returns over the market returns — to the portfolio.
But Why Segregate?:
Savvy investors prefer to keep both the portfolios separate for multiple reasons. The main reason is to efficiently allocate capital to investment ideas. Discipline and patience are two important virtues that make a successful investor. During boom times, you may get carried away and invest more into opportunistic trades. Such a move may hurt your portfolio if the market goes bust. But if you clearly demarcate between the core and satellite portfolios, there will be fewer chances of losing a major part of your money on short-term trading opportunities.
The second reason is based on saving taxes. If you invest fully into core investment ideas, you will have to liquidate the core holdings to raise cash. This will attract taxes. A satellite portfolio keeps the transaction costs arising out of frequent churning low and also helps to avoid increased incidence of tax.
The satellite portfolio also helps investors to efficiently manage their portfolio risk. There are instances where risky short-term trades are lost in multiple investments that you may make. But if you could account a particular trade in the satellite portfolio, then you can track it better.
How Does It Work?:
The idea of maintaining a mental demarcation of 'core and satellite' in all your investment is very appealing. But you must condition your minds accordingly. Since the core portfolio is a long-term portfolio, never compromise on the liquidity of instruments. The core portfolio should always depict safety and liquidity as the key characteristics. Here, safety of capital does not mean that an investor should take no risk or should invest all his money into sovereign bonds. Safety simply means investing in instruments that offer better risk adjusted returns.
So, when it comes to equities, the core portfolio will see investments in funds with a long term track record and blue-chip companies. Liquidity ensures that you can align your core portfolio taking into account the changing asset allocation with a change in lifestyle, risk appetite and advancing age. Moreover, liquidity of instruments makes asset rebalancing easy.
Though core portfolios are comparatively easy to understand, satellite portfolios are a grey area for most investors. Investors find it difficult to get it right in many cases. A satellite portfolio should bring in higher returns, albeit with extra risk. Here, risk should be seen in the context of the portfolio. Let us understand the idea of opportunistic investing with some examples. A risk-averse investor can invest in an index fund for a short time if he has a bullish view on the index. In most cases, index funds appear in the core portfolios of average investors. But for a risk-averse investor with a portfolio tilted towards fixed income, an exposure to index funds means higher risk and, of course, expectations of higher returns. Another case is that of Coal India's public offering which was a good satellite portfolio candidate. Since it was widely expected that the stock will list with a good premium over the offer price, many considered applying for listing gains and it paid off. At times, investors don't mind looking at opportunities in the fixed income space. In the last quarter of 2008, investors looked at long-term gilt funds, when RBI was on a rate-cutting spree. It was a classic case of a satellite allocation that made a quick buck in a space which otherwise is a slow mover. Most long term gilt funds delivered in excess of 25% in that quarter.
Consider another situation. Towards the end of 2010, investors investing in Nifty found the risk-reward associated with Nifty unattractive. "In such a situation why not allocate a small proportion of satellite portfolio to silver futures with a two-month horizon?" asks a fund manager with a broking firm. Silver in an uptrend could have brought in some positive returns when the Nifty was falling. Of course, do note that silver futures are marked-to-market and on the day silver falls, you have to pay the broker to keep your positions.
Special situations can also appear in the satellite portfolio. A small allocation to special situations such as mergers, open offers, delisting makes sense for an investor. Of course, one has to understand risk and reward and be choosy in this space. Special situations make more sense in a falling or rangebound market as in most cases they are market-neutral.
Consider the recent delisting of Nirma. Investors who entered Nirma a month ago have pocketed 14% against a loss of 5% incurred by Nifty over the same time. Not that you always have an attractive special situation to look at. It is a game of patience and discipline.
While investing in trading ideas for the satellite component of your portfolio, always keep track of costs and the risks. Consider HDFC Nifty Index Fund if you are bullish on an index for a short period of time, as there is no entry and exit load with this fund and, more importantly, it does not expose you to the risk of leverage the way Nifty futures do. Investors should also know their ability to take losses. Since these are opportunistic trades, it is essential that investors define exit points in terms of profit-loss levels or based on the investment tenure.
POWER OF TWO
• A core portfolio ensures that your investment goals remain on track
• The core portfolio should include long-term investments
• The satellite portfolio ensures that you earn some extra returns
• Keep only 10-20% of your investible money for the satellite portfolio
• Understand the risks before getting into an opportunistic trade
• Decide on the stop-loss levels and protect your capital
• Never liquidate your core holdings to enter into opportunistic trade
• The satellite portfolio should not be dependent on one investment idea
