Mutual Fund investments can be 'core' and 'satellite'

If you thought terms such as 'core' and 'satellite' are used only in geology or astronomy, think again. These terms are also used to describe mutual fund investment strategies. Broadly, these are used to describe the two parts of a MF portfolio, where one component includes investments in relatively less volatile funds and gives stable returns, while the other is built on top of that to generate extra returns. Let us see how to build your MF corpus based on these strategies.

What is core and satellite?

Core and satellite portfolio management is an investment strategy that incorporates a 'core' portfolio of fixed-income and equity-linked funds which can give relatively better stability, lesser volatility and market-linked returns. This is then topped up with a combination of other 'satellite' funds in search of higher/excess returns and alpha, explains Prasanna Pathak fund manager-equity, Taurus Asset Management.

"The core funds are generally from a lower risk-return matrix and the satellite funds are from a higher risk-return matrix. Also, typically, the satellite portion is more proactively managed than the core," he says.

Since the basic role of the core portfolio is to ensure a risk-adjusted strategy, it has a mix of large cap, midcap, equity and debt. While in the satellite portfolio one can have thematic funds or funds following some unique investment strategy that the investor finds interesting, says Vidya Bala, head of mutual funds research, Fundsindia.com. "Core ensures that you have optimal returns, adjusted for risk and satellite enhances returns of your overall portfolio'', she says.

Core and satellite portfolios are based on the risk taken by the investor and time horizon of the goals. "Core portfolio means the portion of investment which is passively managed; risk is low and kept for long-term period. Satellite portfolio means the portion of investment which is actively managed and the risk and return is high. This portfolio design is advised for diversification of the portfolio and to balance out the risk and returns in longer time frame," says Pradeep Agarwal, CEO, Meri Punji IMF.

How to build core and satellite portfolios

There are different approaches. One of the ways to build a core-satellite set-up can be by combining actively managed funds with index funds and Exchange Traded Funds in a single portfolio. "The appeal of this approach is in that it seeks to establish a risk-controlled portfolio while also securing some prospects of outperformance. In this way, the index/ETF exposure tracks broad markets while the active funds can give alpha from successful managers,'' says Anil Rego, CEO, Right Horizons.

Another approach to build the portfolios is to take a goal approach. For core goals such as retirement, children's education and so on, ensure that your investments are well-diversified and risk-adjusted. Then, if you have money for the long term, but not specifically allocated, you could try new strategies or newer themes for the satellite portfolio.

"The core has to be reasonably diversified, asset-allocated and risk adjusted. That will be a foundation for your investment at all points in time,'' says Bala.

What funds go in each portfolio

For an all-equity strategy, the core portfolio may consist of passive index fund and a few large-cap diversified funds, while the satellite portfolio may consist of a combination of mid-cap/ small-cap and sector-specific/thematic funds, says Pathak.

"The percentages will vary with the age/ risk-appetite/goals of the investor. Broadly, the core should be 50-70% and the satellite portion can be 30-50%," he adds.

According to Rego, for the core portfolio, one can have three large-cap schemes (active funds and index/passive funds) and allocate 75% of your portfolio money by putting 25% in each. For the satellite portion one could look at three thematic funds - such as banking and financial services fund or, small and mid-cap funds and allocate 708% of the portfolio to them. One can also use aggressive hybrid funds as the core portion.

"Since the core portfolio will address long-term financial goals, the time horizon should be at least seven years and above. The satellite portion can be used to address shorter-term financial objectives. The return expectations will vary according to fund selection. Mid- and small-cap funds, thematic funds, and sectoral funds can give much higher returns at greater risk,'' Rego adds.

Returns and review of the portfolios

If the returns in core portfolio are volatile that is a bigger worry than returns in satellite being volatile. This means you have to take a relook at how your core has been built, points out Bala.

"Probably the core was not well diversified or well allocated in the first place. Or you had some funds which ideally should have been in the satellite are sitting in the core and causing volatility in the core,'' she says.

For instance, you may have a chunk of investment in say, a banking fund, which can be highly volatile. It is cyclical and moves with the market. In other words, it is a beta fund. Having that in the core will definitely disturb the portfolio returns.

"Then again, sometimes it could be because of the nature of the fund itself or because of the higher allocation you have. For instance, it's ok if you have allocated say 5% to banking fund. It may not impact your overall core portfolio returns. But if you have a 20% allocation it may start impacting - positively or negatively. These risk-adjustments have to be made to your core portfolio,'' Bala explains.

The holding period of both portfolios depends on the requirement of the investor. The core portfolio can be used for short-term as well as long-term duration. "In satellite portfolio the risk-return quotient is high, so it should be kept for long-term duration where the return is higher in the long run. From core portfolio one can expect a return of an average 10-12% and from satellite portfolio an average return of 15%, which can go higher depending on holding period," says Agarwal.

Remember that core does not mean no risk. Core just means allocating in such a way that return is optimised, sums up Bala.