Building A Satellite Portfolio
The primary goal of satellite investment is to juice up your overall returns. By their design they should be poorly correlated to the core part of your portfolio. However, satellite investment strategy requires an active management of funds and this article provides guidelines on how you can go about doing so
The returns of the last one year in equity-dedicated fund have been characterised by strong gains in some of the sectoral funds. Equity funds dedicated to sectors such as IT and energy have generated returns in excess of 100 per cent over the past 12 months compared to around 60 per cent by large-cap-dedicated funds in the same period. The best performer, however, was the category of small-cap funds that grew by more than 115 per cent in the same duration.
Nevertheless, if you go back a couple of years, you will find that most of the funds from this category were laggards and were down by almost 30-40 per cent in one year. So, the current spectacular returns by these categories should be analysed against the background of their underperformance of the last few years. These sectoral, thematic or broader market funds are akin to spices in your dish that add distinct taste and flavour. Nevertheless, they cannot be the main ingredient of your dish. The key to build a strong and robust portfolio of funds is to make sure that you have selected appropriate, high-quality stocks and bond funds to serve as the core of your portfolio. But what if you want to add some ‘chutzpah’ once you have made your core positions? There are categories of funds that will lower the overall volatility of your portfolio while there are others that will add some vigorous spirit to the overall returns.
The investment decision process primarily consists of the following four steps.
✓ Setting the long-term asset allocations, as for example, bond, stock or cash allocation.
✓ Establishing the investment policy and rebalancing the parameters.
✓ Determining the allocation between active and passive.
✓ Selecting funds.
✓ Assessing ongoing management—performing tactical activities and monitoring and replacing funds, if required.
The first two points are arguably the most important decisions when it comes to making investments and moreover they are relatively easy compared to other decisions. Despite this we see that these decisions are given the least attention. The first two steps will help you to design a ‘barbell’ portfolio into two strategic baskets – core and satellite. The following paragraphs will guide you on how to build a satellite portfolio around your core portfolio.
Satellite Portfolio
The core and satellite design of a portfolio has been popularised in the last couple of decades. However, it has been in existence in one or another form with investors having a high proportion of their portfolio in virtually risk-free assets and a small part exposed to the risk of total loss. This aspect of barbell practice was designed to help the investor manage risk, which was then ostensibly defined in terms of absolute downside risk. Satellite investment strategy requires an active management of funds. The primary goal of satellite investment is to juice up your overall returns. By their design they should be poorly correlated to the core part of your portfolio.
However, risk reduction is only a secondary benefit and may not be the primary factor to select your satellite portfolio. Besides, satellite investments need not be consistent in style, low risk, liquid or cost or tax-efficient. The only criterion for consideration of a satellite investment is that it should be the right investment vehicle or strategy which is fundamentally sound and not a fad. Basically, it should be in trend. Besides, the expected net return should be greater than what is expected from your core portfolio. Such a loose definition of what can be part of your satellite investments opens up a door for many funds that have the potential to be a part of your portfolio. Therefore, there is a need to balance opportunity and risk in any decision regarding the number of satellite investments that may be included.
There is no exact mathematical model to determine the optimum number of investments in a satellite portfolio. Having fewer funds in the satellite portfolio can significantly increase the risk to the overall portfolio in case of any wrong choice. On the flip side, larger numbers of allocations may add little to the alpha generated by satellite investments as additions are more likely to reduce risk than increase returns. Finally, given the effort necessary to select and monitor satellite investments, the effort of incorporating more satellite funds may outweigh the benefit. Hence, one can consider four to six satellite positions.
The funds that can be part this strategy are international funds, small-cap funds, thematic funds and sectoral funds in an equity portfolio while credit risk funds, dynamic bond funds and long-duration funds can be added to your debt portfolio. Risk profile analysis remains the first step in deciding the right satellite portfolio. Your goals, personal situation, preferences and risk tolerance need to be considered to assess your risk profile and then matched to an appropriate asset allocation across equity, commodity, fixed interest, cash and other assets. We will talk only about the equity portion of the satellite portfolio.
International Funds
In 2020, technology-heavy Nasdaq generated return of almost 44 per cent over and above the 35 per cent return it generated in 2019. Other international funds also generated decent returns last year. International funds, also called overseas or global funds, are offered by Indian mutual funds. These schemes invest in foreign companies listed on overseas’ stock exchanges. They offer you a variety of funds that invest predominantly in the US, Europe, Japan, Brazil, China and other Asian and emerging markets. Theme-based international schemes focusing on themes such as commodity also form a part of their offerings. With a rise in commodity prices recently, many of these funds have delivered superior returns.
The importance of international diversification can best be understood by the return generated by Parag Parikh Flexi Cap Fund (erstwhile Parag Parikh Long Term Equity Fund) that has consistently invested around 27 per cent of its assets in international equities. This fund from the flexi-cap category has generated annualised return of around 20 per cent in the last five years. Compare this with its category that has generated return of 14.4 per cent in the same period. Investment in international markets can smoothen out the volatility of portfolio returns as, historically, global equities have not moved in tandem. This can be understood by studying the correlation of returns between different international equity markets.
In order to understand this, we have analysed the performance of six equity indices across different geographies such as US, Japan, Hong Kong, UK, India and Korea. The period of analysis is from 2011 to 2020 and it appears that none of them are highly correlated except for DJIA representing the US equity market and FTSE representing the UK market.
S & P BSE Sensex representing the Indian equity market does not have high correlation with any of the major markets. Therefore, it makes sense to diversify into international funds. While it is important to select the right kind of international fund, you first need to check if it has lower correlation with the Indian market. The second important factor is the style of the fund that you select. The investment style you choose should depend on how much risk you can handle and the other funds in your portfolio. If your domestic funds lean toward growth stocks, consider a foreign fund that’s more inclined towards value.
Foreign markets are often influenced by different factors than the domestic market and so adding foreign funds to your investment mix gives you a better chance of always owning something that’s performing well. Before investing in any international fund, understand the cost involved in terms of tax status and exit fees. They are treated more like debt funds and if you exit before three years you may have to pay short-term capital gain tax.
Small-Cap Funds
Last year, it was small that was beautiful. The best performing funds over the past 12 months were small-cap-dedicated funds. The NAVs of funds from this category on an average doubled. Large-cap-dedicated stocks also performed better and generated double-digit returns but these were much below the small-cap funds. Nevertheless, it is not always the case. It makes sense to be especially circumspect with small-cap funds because they can be a lot more volatile than large-caps with the same investment style. It has been seen that between 2018 and end of 2019, small-cap-dedicated funds saw their NAVs declining by more than 40 per cent.
In fact, small value funds tend to have more dramatic ups and downs than their large-cap counterparts. Small blend is more volatile than large blend and so on. Hence, your best bet is to own a mix of large-cap and small-cap-dedicated stocks. You will benefit when the market favours one type of stock without missing out completely when investors turn to the other. For most investors, small-cap dedicated funds should represent between 10-15 per cent of the equity portion of their portfolios. While selecting such small-cap funds, bigger might not be better.
Bigger the AUM of the funds, the harder it is for managers to run and they are not likely to enjoy the same level of performance as compared to smaller, more nimble funds because a small-cap fund manager needs to buy small companies. Funds that grow too large are not untouchable after all, they wouldn’t have gotten large in the first place if they didn’t have talented managers—but their returns may drift toward the category’s middle if they have become bloated. Hence, while selecting a small-cap fund keeping other things constant, the AUM of the fund should not be around the median of the category AUM.
Sector Funds
Funds dedicated to sectors such as IT and healthcare were some of the best performing sectoral funds in the last one year. There might be various reasons for such a superior performance and this might have lured many performancechasing investors towards them. Nonetheless, ideally a sector fund might not be necessary if you have a well-diversified portfolio. Adding more sector funds might tilt your portfolio towards a particular sector, which might increase the vulnerability of your overall portfolio.
What also hurts portfolio performance is joining the party late. The pattern of buying too late is a common one with sector-fund investors. Fund houses also try to capture this by launching various funds dedicated to hot sectors. At the end of 2007 we saw various infrastructure funds being launched. Investors of such funds are yet to get decent returns. In the last one decade many of the funds have generated annualised returns in single digit.
Nevertheless, if you believe that the sector in vogue is underrepresented in your portfolio, you can make it part of your satellite portfolio. It pays to take a contrarian stance rather than chasing trends. Precisely because investors typically do not have such good timing, you can often outperform by buying what most investors are selling. We saw this in healthcarededicated funds. Once the hottest, they went through severe under-performance after 2016. At the mid of 2018, not a single fund had generated positive return in a three-year timeframe and in a five-year timeframe of 2013-2018 there was not a single fund that generated annualised return in double-digits. Similar is the case of many commodity funds that have outperformed the market hugely in recent times.
That doesn’t mean you should automatically rush into whatever sector is most out of favour. Do some research and analyse the sector and the funds to make sure you understand why the sector is unloved and to confirm that it has good potential. For example, the current outperformance of the IT sector can be traced back to spending throughout the last 3-4 years to build digital capabilities. This is now in demand as digital adoption has accelerated by 2-3 years given the new reality of physically remote and digitally connected world. Similarly, India’s positioning as a pharmaceutical powerhouse has been strengthened by the critical role played in global vaccine supplies.
Building a Robust Portfolio
One of the most effective ways to build a robust portfolio is through core and satellite portfolio construction. Core investments should be such that they are more stable and provide a broad foundation to the portfolio. These may comprise large-cap funds, flexi-cap funds or value funds. On the other hand, satellite investments should be tactical in nature to provide diversification and the potential for higher return. To start with, you can allocate 20-30 per cent of your equity to satellite investments. These satellite funds should be actively managed and can be used to make the entire portfolio more tax-efficient. For example, investment such as ELSS that qualifies for deduction under Section 80 C of the IT Act 1969 can be part of such satellite investment. Besides, you can effectively use investments in satellite funds for long-term capital gain harvesting, which requires frequent churning of the portfolio. Hence, satellite investment will help you to generate better post-tax returns