PORTFOLIO POINT: Keeping the bulk of a portfolio’s funds in index investments, and using the remainder to invest in other areas, can increase average potential returns.

An increasingly common approach to investment management is the ‘core and satellite approach’.

This encourages people to hold index-style investments (low-cost investments with broad market exposure, such as index funds and exchange-traded funds) as the core of their portfolio while then using some further funds to try and increase their market return.

One of the biggest criticisms I come across of index investing is that it stops you from getting anything more than the average market return, less some costs. While this is true, it does prevent you from getting a less-than-market average return. This is an important point to keep in mind. When we talk about an average market return, it is worth keeping in mind that while some people will get a return higher than this, another larger group of people will get a return lower than the average.

The reason the group of people who underperform is larger than those who beat the market is because investors will all have some costs – trading costs, management costs, education costs, buy-sell spreads, tax costs and administrative costs – which reduce the average return.

Based on research by highly regarded academic Ken French (‘The Cost of Active Investing, 2008), it is not unreasonable to put the cost for investors in Australia as being at least 1% a year. So, if we expect the total return from investing in shares in the future to be 10% a year, the return after costs will only by 9% a year – reducing the number of people who actually ‘beat’ the market’s 10% a year.

There are three key reasons that I think the idea of a ‘core and satellite approach’ might help portfolios – especially the use of index style investments as the core of a portfolio:

1. It does take away the chance of substantial underperformance
2. It helps increase the potential average return of a portfolio
3. It will help investors to not make some of the behavioural biases that can reduce returns – especially the tendency to sell winning investments, and hold the losing investments until they ‘come good’.

Let’s consider these one at a time.

1. Taking away the chance of substantial underperformance (compared to the index/average return)

At any point in time, the top 10 companies in the sharemarket index make up about 40% to 50% of the average market (The table below shows the current top 10 companies in the index). Most individual investors don’t hold this level of the top 10 companies at all – often having higher levels of smaller companies. This means that they can potentially get significantly different, and on occasions lower, returns.

During the period of the global financial crisis small companies performed worse than large. During a time when the overall market fell by 50%, individual investors who held more of their investments in small companies were exposed to greater losses – hardly what you want during one of the most challenging times.

The use of some money in index-style investments helps moderate potential underperformance against the average market return.

Top 10 Holdings – ASX 200 Index

As of July 16, 2012

2. It increases the potential average return of a portfolio

This is a pretty controversial idea – that indexing can actually increase the average return of a portfolio – and it focuses on the role of costs in investing.

William Sharpe, who has a Nobel Prize in economics, wrote an important paper entitled ‘The Arithmetic of Active Management’.  In it, he stated that: “Properly measured, the average actively managed (that is not using an index fund) dollar must underperform the average passively managed (using an index style fund) dollar, after costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

Behind this statement is a simple calculation of costs that we alluded to before. If the future return from markets is 10% a year, and the costs of using an index strategy is 0.5% a year, and the costs of an active strategy is 1% a year, then the average return from indexing will be 9.5% a year, and from an active strategy 9% a year.

No doubt many Eureka Report subscribers pay careful attention to costs in their active strategies – however many of the costs are quite subtle. They are things like buy/sell spreads (more of an impact in an active strategy that might trade more often and target smaller companies), transaction costs (more trading likely in an active strategy), greater research costs. This does not take into account the cost of your own time (although for many people investing is an enjoyable hobby).

3. It will help investors to not make some of the behavioural biases that can reduce returns – especially the tendency to sell winning investments, and hold the losing investments until they ‘come good’.

The area of study of ‘behavioural finance’ is growing, and is of particular interest for investors. Barber and Odean, USA researchers, looked at the role of trading. They looked at a large sample of online investment accounts, and found that female investors were better than men. Why? Because they traded less. The researchers put this excessive trading down to overconfidence – people thinking they had the ability to pick better performing shares, when in fact the results show they did not.

An indexed portfolio core protects this part of the portfolio from overtrading – it is a simple investment with very little trading activity at all.

Another behavioural bias is that people tend to sell stocks that have done well (‘no one ever went broke taking a profit’), while holding stocks that had fallen in value (‘until they come back, and then I’ll sell them’). This is not a great strategy from a tax perspective – because you have to pay capital gains tax on profitable trades. It is also not a great strategy given the evidence that stock prices show some level of ‘momentum’. That is, prices that have gone up have a higher-than-expected chance of going up again, and prices that have fallen have a higher-than-expected chance of falling again. So, selling winners and holding losers is not a great strategy given this evidence.

Conclusion

The core and satellite investment strategy seems to be growing in popularity. It makes some sense – a low-cost core to a portfolio that might protect investors from the mistakes of overtrading and overconfidence is an idea worth considering.