What is a core-satellite strategy and why is it so powerful?

In essence, core-satellite is an investment approach that combines the benefits of index funds—lower cost, broader diversification, tax efficiency and lower volatility— with actively managed funds or other direct investments offering potential for outperformance.

It recognises that there are fundamental differences between index and active fund management but that it doesn't have to be either-or. Rather, investors can combine the best aspects of both investment strategies to bring stability and returns to an investment portfolio.

Core-satellite also brings greater discipline and stability to an investment portfolio by:

• Reducing reliance on 'picking winners' or chasing returns

• Providing greater portfolio diversification

• Potentially improving after-tax returns by taking maximum advantage of capital gains discounts

• Reducing overall fund management and transaction costs

The fundamental importance of asset allocation

Research in both Australia and overseas has consistently concluded that asset allocation is by far the greatest determinant of portfolio outcomes. Security selection and market timing only have minor influence, particularly over the long term.

The core-satellite approach is first and foremost focused on getting an investor's allocation right and ensuring a diversified mix of assets, and then deciding how much of each asset class to allocate to index and active or individual securities.

Implementing a core-satellite portfolio

1. Determine your risk profile and asset allocation

Risk profile analysis remains the first step in portfolio construction formulation. An investor's goals, personal situation, preferences and risk tolerance, all need to be considered to build an investor's risk profile—then matched to an appropriate asset allocation across shares, property, fixed interest, cash and other assets.

2. Decide how much of the portfolio to allocate to the "core" and "satellites"

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 direct shares. This can be dependent on the level of risk compared to the market 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 interest—it may be appropriate to have 100% indexed.

3. Select your investment managers

Finally, you need to decide on an index manager for the 'core' (not all index managers are the same), as well as the number of active managers '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.