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Investing insights-core-satellite

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Core/satellite investing

Core/satellite investing

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  • 1. In today’s volatile markets, some investors may want to look beyond traditional investing strategies. They might consider designing a portfolio with potential to outperform market indices over the long term while taking advantage of short-term market opportunities that could help dampen the impact of market fluctuations. An effective way to achieve this is by constructing what’s known as a “core-and-satellite” portfolio. The “core” helps investors withstand volatility because these tend to be long-term investments spread across a range of stocks and bonds, says Mike Loewengart, Director of Investment Strategy for E*TRADE. The “satellite” positions may be more actively traded, allowing investors to target investments they think are ready to grow and that can help diversify the portfolio, as well as poten- tially offset negative stock and bond returns. How It Works Core and satellite portfolio construction divides your investment portfolio into two parts. The core portion of the portfolio — which typically ranges from 60% to 90% of total assets — is held in low- cost equity and bond investments, such as broad stock and bond mutual funds, ETFs, index funds or “balanced” funds/ETFs that contain a prescribed mix of stocks and bonds that can be selected to fit the investor’s need. The overall asset allocation within the core holdings should align with your personal investing objectives and time horizon. Also, because one of the goals of this strategy is to minimize costs, Loewengart recommends investing in mutual funds or ETFs with expense ratios of less than 1%. For example, investors seeking an allocation target of 60% equities and 40% fixed income might spread their core position among a few funds or ETFs that give them exposure to a broad range of domestic and international stocks and bonds. Or they might choose to invest in just one low-cost balanced fund or ETF that typically keeps 60% in equities and 40% in fixed income. The satellite portion — usually 10% to 40% of the total portfolio — is used to achieve two goals: First, investors can pursue greater long-term returns by adding or overweighting specific sectors, subsectors or individual stocks that they anticipate will outperform the investments in the core por- tion over the short term. At the same time, these investments can be used to build a hedge against market volatility by incorporating asset classes that have lower correlations with those in the core group, meaning they are likely to perform somewhat differently under the same market conditions. Commodities, for instance, tend to have a low or negative correlation with traditional assets like stocks and bonds because they respond differently to economic cycles. The satellite portion of the portfolio could, for instance, be spread across various asset classes that the investor wants to overweigh, such as emerging markets, growth and small-cap equity funds. It could also include alternative assets, such as real estate or commodities, or even individual stocks that the investor believes are well positioned for growth. Core and Satellite Investing E*TRADE Capital Management Core and Satellite Investing: Cost Efficiency with Potential for Healthier Returns Investing Insights
  • 2. A Customized Approach How investors divide their portfolio between core and satellite will depend on their risk tolerance and how much of a hands-on role they want to play in maintaining their portfolio. An investor seek- ing a less-involved role may want to keep a higher allocation in his or her core portfolio, Loewen- gart says. That’s because building and monitoring the satellite portion often requires more analysis and more regular oversight, which may involve a lot of additional time. The core holdings generally are meant to be purchased for the long term and thus only need oc- casional rebalancing to maintain their target asset allocation. The satellite holdings will need closer monitoring and maintenance, he says, because they may be more volatile and grow or decline more quickly in comparison to the core holdings. So investors may need to trim back satellite posi- tions that have outgrown their asset allocation target or to make changes to them based on per- ceived market opportunities. While the ratios between core and satellite can vary among investors, your core holdings should comprise the bulk of the portfolio, Loewengart says. Find a Benchmark to Track Returns Since you are using two different investment strategies within your portfolio, it’s important to estab- lish a benchmark against which you can measure your overall performance, advises Christine Benz, Director of Personal Finance for Morningstar.com. That benchmark could be a market index, such as the S&P 500, that allows you to compare whether your core-satellite portfolio is indeed outper- forming the broader equity markets. The chart below shows historic correlations (1997 – 2012) between the S&P 500 Index and other types of market indices, including domestic and international stocks, specific stock sectors, bonds, commodities and REITs. The lower the ratio listed on the matrix, the less that index performed similarly to the S&P 500 for that particular year. A negative ratio means the index moved in opposite directions from the S&P. Investors can use this information to help select funds and ETFs for their satellite positions that have lower or negative correlations with their core positions. For example, someone with a core position that tends to closely echo the performance of the S&P 500 index may want to look at whether adding precious metal investments or commodities to their satellite posi- tions makes sense. Both of these sectors in the matrix show very low correlations over the years. (For details, see the chart.) Correlation Matrix: Returns vs. S&P 500 July 1997 - June 2012 Core and Satellite Investing SOURCE: Zephyr StyleADVISOR
  • 3. Investors will also want to periodically check their satellite investments to see if they are fulfilling their purpose and outperforming the core portfolio over a longer time frame of at least a year. “The challenge with the satellite piece is making sure that you’re adding value,” Benz says. Done right, however, a core-and-satellite strategy may deliver an investing trifecta: market-beating performance, lower volatility and lower investment costs in one flexible portfolio tailored to meet your specific needs. Core and Satellite Investing
  • 4. All investments involve risk, including loss of principal amount invested. For more detailed discussion about the risks of investing in a mutual fund or ETF, as well as the fund’s investment objectives, policies, charges, and expenses, please read the fund’s prospectus. This article is distributed for informational purposes only. It contains current opinions of E*TRADE Capital Management, LLC. The investment ideas and expressions of opinion may contain forward looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell securities. E*TRADE Capital Management’s statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. Each investor should consider his or her unique personal objectives, risk tolerances and time horizons when making investment decisions. Past performance is not an indication of future returns. Diversification strategies do not ensure a profit and cannot protect against losses in a declining market. All investments involve risk, including the loss of principal amount invested. Data and statistics contained in this commentary are obtained from what E*TRADE Capital Management considers to be reliable sources; however, its ac- curacy, completeness, or reliability cannot be guaranteed. Stocks fluctuate in response to the activities of individual companies and general market conditions, domestically and abroad. Investments in mid and small-cap stocks typically have higher risk characteristics than large cap stocks and may be subject to greater price fluctuations than large-cap stocks. There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Lower-quality fixed-income securities gener- ally offer higher yields, but also carry more risk of default or price changes due to potential changes in the credit quality of the issuer. Municipal Bonds are subject to market and interest rate risk if sold prior to maturity. Treasury securities are guaranteed by the US government as to timely payment of principal and interest. Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets. Because of commodity price volatility and the increased impact such volatility has on profitability of commodity investments or related companies, there are additional risks involved with investing in commodities. Commodity prices could be affected by sharp price volatility caused by global, economic, financial, and political factors. Resource availability, government regulation, and economic cycles could also adversely affect these securities. Investing in Commodities, REITS, and International or Global investments carries certain risks such as price volatility, currency risk, market risk, interest rate risk and credit risk. An investor should fully understand these risks before making an investment. REITS or other real estate investment vehicles are subject to similar risks associated with direct ownership of real estate, including losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, zoning laws, regulatory limitations on rents, property taxes and operating expenses. Alternative investment strategies are not for everyone and entail risks that are different from more traditional investments. Alternative investments are intended for sophisticated investors and involve a high degree of risk, including the potential for loss of some or all principal. Correlation is a statistical measure of how often market returns tend to move in the same direction. A correlation of 1 implies that returns tend move in the same direction. A correlation of 0 implies that returns move independently of each other. A correlation of -1 implies that returns tend to move in opposing directions Indices used in this presentation are intended to provide a general measure of the market performance for a particular asset class or type. An Index is an unmanaged portfolio of predetermined securities and does not reflect any initial or ongoing expenses such as brokerage fees, commissions, principal mark- ups, management fees or taxes. The inclusion of any one of these items would reduce the performance shown. It is not possible to invest directly in an index. S&P 500 Index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the US stock market. For additional information about the indexes shown in the Correlation Matrix Chart above, please visit etrade.com or call an E*TRADE Financial Consultant at 800-760-9036. The E*TRADE Financial family of companies provides financial services including trading, investing, investment advisory, and related banking products and services to retail investors. Full portfolio management and advisory services are offered through E*TRADE Capital Management, an investment adviser registered with the Securities and Exchange Commission. Upon request, we will send you a free copy of E*TRADE Capital Management’s Form ADV Part 2A, which describes, among other things, affiliations, services offered and fees charged. Prior to investing in a managed account, E*TRADE Capital Management will obtain important information about your financial situation and risk tolerances and provide you with an account information package, which includes a detailed investment proposal, the investment advisory agreement, and wrap fee program brochure. These documents contain important information that should be read carefully before enrolling in an investment advisory managed ac- count program. © 2012 E*TRADE Financial Corporation. All rights reserved.