Importance of Passives Funds in Core and Satellite Portfolio Strategy

What is meant by a Core and Satellite Strategy?

1. Core Portfolio: This is the main part or the core of your investment portfolio. The primary objective of your core portfolio will be to achieve your long-term financial goals. Diversification, stability, and growth should be the main characteristics of core portfolio. Your core portfolio should primarily comprise of passive funds, diversified equity funds and hybrid funds. Proper asset allocation based on your risk / return objectives, you should select funds based on risk appetite and financial goals. Systematic Investment Plans (SIPs) are suitable for investing in your core portfolio for the purpose of long-term wealth creation through the power of compounding. However, you can also invest in lump sum or through Systematic Transfer Plans.


2. Satellite Portfolio: The satellite portion of the portfolio consists of funds which have the potential of giving higher returns but may also have relatively higher volatility associated with it. The objective of your satellite portfolio is to boost your overall portfolio returns. Your satellite portfolio may comprise of sectoral funds, thematic funds (both active or passive), or international funds that can outperform the broad market in certain market conditions. This segment is more dynamic and allows for tactical adjustments based on market conditions or emerging trends.

Why Core and Satellite Approach?

1. Diversification: The Core and Satellite approach to investing ensures diversification across asset classes, sectors, and geographies.


2. Focus on financial goals: Link your core portfolio with your financial goals, with the idea of balancing risks and returns to achieve your goals.


3. Flexibility: The satellite portion allows investors to also capitalize on short-term market opportunities without disturbing the long-term goals of the core portfolio.


4. Expense efficiency: Inclusion of passive managed funds in the core portfolio can reduce the overall portfolio expense. Lower expenses can contribute to higher returns in the long term due to compounding effect.

The increased significance of passive investments

Passive investing has gained in popularity in India in recent years. As per AMFI data, passive assets under management (AUM) multiplied six times in the last 5 years (as on 31^st December 2024). ETFs account for 73% of the passive AUM, while index funds account for around 27% of the passive AUM. Passive funds do not try to beat the benchmark market index; instead, they track the benchmark index i.e., aim to replicate the performance of the benchmark index.

Why should passive funds be part of your core portfolio?

1. Low cost: Total Expense ratios (TER) of passive funds is much lower than actively managed funds. The fund manager of an active fund will have to generate significant alphas on a consistent basis to match the performance of a passive fund tracking the same benchmark index. Suppose the TER of an active fund is 1.5%, while that of a passive fund tracking the same benchmark index is 0.20%. This difference in costs implies that the active fund will have to consistently beat the benchmark by at least 1.30% to match the performance of the passive fund. Since funds in your core portfolio would have long investment horizons, lower cost of passive funds can give it a significant advantage.


2. No unsystematic risk: The fund manager of an active fund needs to be overweight or underweight on certain stocks in the index to beat the benchmark index (create alphas). This will result in unsystematic risks or stock/sector specific risks. Unsystematic risk can lead to outperformance or underperformance depending on market conditions. There is no unsystematic risk in passive funds because the fund simply tracks the benchmark index – it does not aim to beat the benchmark index.


3. No human biases: Fund manager biases can impact the performance of active funds. Additionally, the change of the fund manager of an active fund for any reason can affect the returns of the fund. There is no human bias in passive funds.

How to construct a Core with passive funds?

You can construct your core portfolio with broad market equity ETFs or index funds (e.g. Nifty 50, Sensex, Nifty 500 ETFs / Index Funds etc.) along with equity and aggressive hybrid funds. For purposes of asset allocation, you can also invest in fixed income ETFs and commodity (e.g. Gold, Silver) ETFs / FOFs. Gold and / or silver ETFs / FOFs can also provide investment solutions for life-stage financial goals like children’s marriage etc.

For Satellite portfolio

You can use thematic or sectoral ETFs to invest in specific industry sectors like banking, IT, pharma etc or broader themes like consumption. You can include smart beta funds (ETFs or index funds), which select stocks based on certain specific criteria like value, dividend opportunities, quality, volatility etc. Smart beta funds can produce superior risk-adjusted returns compared to the market. International ETFs / FOFs can provide you exposure to international equities. International equities have low correlations with domestic equities and can provide richer diversification to your investment portfolio.

Core vs. Satellite Allocation

The allocation between core and satellite will strictly depend on the investors’ risk appetite, individual financial goals, and investment horizon. Typical core portfolio allocation to your portfolio can range from 70 – 80%. Investors with higher risk appetites can allocate a higher percentage of their assets in their satellite allocation.

Rebalancing is an essential aspect of the core and satellite strategy. Over time, market movements may skew the portfolio’s original allocation. For instance, during a bull market, the satellite portion might outperform and dominate the portfolio. Regular rebalancing is necessary to maintain the desired proportion and to make sure that the portfolio stays aligned to your risk profile and financial goals in changing market conditions.

Conclusion

Core and Satellite strategy is one of the most tried and tested ways for building a resilient and growth oriented mutual fund portfolio. Passive funds can play a key role in core portfolio and can also be part of satellite portfolio along with active funds. Passive funds can reduce overall portfolio costs and unsystematic risks. Tactical allocation to thematic and smart beta passive funds can also produce alphas in your portfolio. Consult with your financial advisor or mutual fund distributor about your core and satellite allocations, and how passive funds can play a role in both parts of your portfolio.