We use the following portfolio construction and investment concepts and strategies to build customized portfolios for clients primarily using Exchange Traded Funds in a Unified Managed Account structure:
Core and Satellite investing approach
Core/satellite investing is a method of portfolio construction designed to minimize costs, tax liability and volatility while providing an opportunity to outperform the broad capital market as a whole. The core of the portfolio consists of passive investments that track major market indexes, such as the Standard and Poor’s 500 Index (S&P 500) and/or the Barclays Capital Aggregate Bond Index. Additional positions, known as satellites, are added to the portfolio in the form of actively managed investments. The conventional view of the core-satellite methodology suggests it is prudent to use index funds for markets that are deemed efficient and to use active managers in areas considered to be inefficient, where the managers are presumed more likely to succeed.
The following chart illustrates the core (beta) and satellite (alpha) philosophy:
Alpha vs. Beta
When an investor separates a single portfolio into two portfolios, an alpha portfolio and a beta portfolio, he or she will have more control over the entire combination of risks to which he or she is exposed. By individually selecting your exposure to alpha and beta, you can enhance returns by consistently maintaining desired risk levels within your aggregate portfolio. Understanding the following terms will help in understanding the difference between alpha and beta sources of risk:
The return generated based off of idiosyncratic risk (see below).
The return generated from a portfolio that can be attributed to overall market returns. Exposure to beta is equivalent to exposure to systematic risk (see below). The alpha is the portion of a portfolio’s return that cannot be attributed to market returns, and is thus independent from market returns.
The risk that comes from investing in any security within the market. The level of systematic risk that an individual security possesses depends on how correlated it is with the overall market. This is quantitatively represented by beta exposure.
The risk that comes from investing in a single security (or investment class). The level of idiosyncratic risk an individual security possesses is greatly dependent on its own unique characteristics. This is quantitatively represented by alpha exposure. (Note: A single alpha position has its own idiosyncratic risk. When a portfolio contains more than one alpha position, the portfolio will then reflect each alpha position’s idiosyncratic risk collectively.)
Alpha and beta expose portfolios to idiosyncratic risk and systematic risk, respectively; however, this is not necessarily a negative thing. The degree of risk to which an investor is exposed is correlated to the degree of potential return that can be expected.
Active vs. Passive
Active investing means trying to beat the market over a particular time period using one or both of the following strategies:
Security selection. This is a fancy term for buying the right stocks (or bonds, or funds, or any other asset) and avoiding the wrong ones. It means having the foresight to buy Apple in the pre-iPod days and not to buy Netflix on the day after its IPO.
Market timing. Markets gyrate. If you can correctly predict those gyrations ahead of time, you can make a lot of money—or avoid losing it.
Passive investing means doing neither of those things. It means diversifying as much as possible by buying broad market index funds. It means owning the next Apple, but also the next Groupon. And it means not trying to time the market. That means staying in when stocks take a dive five days—or months, or years—in a row. Passive investing also means making portfolio decisions based on personal circumstances, not on headlines or research. Passive management, or indexing, has been gaining greater acceptance as an investment approach among investors. This acceptance has come in no small part because numerous academics and financial publications have been quick to point out that investment managers do not consistently beat the market, i.e., regularly outperform a relevant index such as the S&P 500 or Russell 2000 Indexes or an index-based passive strategy. Indexing can help investors reduce their investment costs by reducing transaction costs, slippage, and the higher fees charged by active managers.
Active and passive investments do not need to be mutually exclusive. Just as allocations to the developed and new growth markets, or to equities and bonds, can be complementary, we believe that active and passive investments can serve different needs in the same portfolio. Over the past decade, we have seen periods of extreme macro-driven equity performance, the proliferation of index investment options and numerous articles favoring passive management. Increasingly, investors have been presented with the argument—why not just go passive? While we believe that passive investing has its benefits there are several variables, such as time horizon and index distortion, that investors should consider before making a decision. In our view, investors seeking to make a strategic allocation to equities should obtain a more nuanced understanding of both active and passive approaches to determine their optimal investment strategy.
Strategic Asset Allocation vs. Tactical Asset Allocation
Strategic asset allocation calls for setting target allocations and then periodically rebalancing the portfolio back to those targets as investment returns skew the original allocation percentages. The concept is akin to a “buy and hold” strategy, rather than an active trading approach. Of course, the strategic asset allocation targets may change over time as the client’s goals and needs change and as the time horizon for major events such as retirement and college funding grow shorter.
Tactical asset allocation allows for a range of percentages in each asset class (such as Stocks = 40-50%). These are minimum and maximum acceptable percentages that permit the investor to take advantage of market conditions within these parameters. Thus, a minor form of market timing is possible, since the investor can move to the higher end of the range when stocks are expected to do better and to the lower end when the economic outlook is bleak.
Capitalization Weighted vs. Fundamental Weightings
Fundamentally-weighted indexing is a relatively newer methodology. Fundamental weighting may be referred to as “factor investing” or “smart beta” and constructs indexes based on metrics other than capitalization. Some common factor index construction methodologies might be dividends, earnings, cash flows, etc.
At Endowment Wealth Management®, we believe that there is no right or wrong answer and that each potentially has their place in a portfolio. Typically, we will use a cap-weighted index at the core of a portfolio obtain market exposure to help keep overall portfolio costs low. We then seek to enhance overall returns by augmenting that core holding with fundamentally-weighed indexes.
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