Saturday, August 9, 2008

Core/Satellite Approach, Passive/Active Investing

Do not jeopardise your investment returns by buying products without regards to the whole portfolio as this is likely to increase your risk without necessarily increasing your returns.

Some financial advisors/bankers will tell you to buy products and they might not even know what a portfolio should consist of. However, if you have more than 50% of your fund invested into asian equities, buying another asian growth fund means you will take more risk and reduce returns should asian equities tanked. They are more interested in generating more sales from you. Stay away from these advisors/bankers.

Other advisors/bankers might advise you to invest with a portfolio approach, though they would just give you a few products and ask you to put more money in regularly to this portfolio. This might not be optimal since you will be mixing two conflicting objectives into your portfolio. Most of us want both wealth preservation and appreciation. Wealth preservation will mean your investments in the portfolio will generally tend towards more conservative investing but also with potential for appreciation. Wealth Appreciation will mean your investments need to be more aggressive and you will be considering more of the returns. When you mixed this two objectives in one portfolio, it's unlikely you will find an investment that fulfills both at the same time.

A better approach might be the core-satellite approach used by private banking clients. The Core Portfolio will have your Wealth Preservation Objectives and consist of investments that fulfil this criteria. It might be your typical 60% bond, 40% equities asset allocation (which historically have served investors well). The Satellite Portfolio will try to fulfil your Wealth Appreciation objective and have investments that are more aggressive or with your views that it might outperform the market. These investments are usually investment themes or major trends you wish to take advantage of like water/energy/infrastructure. Though it could also be a company shares that you believe will appreciate in the near term.

A core-satellite approach allows you to maintain a significant amount(eg 80%) of your fund in a wealth preservation portfolio while the balance (20%) invested in a wealth appreciation portfolio. This takes into account human tendency to want to outperform the market and constantly meddling with the investments. With this approach, you can fiddle with your satellite portfolio and try to minimize the fiddling on your core portfolio (apart from the rebalancing). And if your aggressive portfolio does not do well, you will not be financially devastated as well.

In a core portfolio, most people will probably be using Passive investment like index funds/etfs to mirror the market returns. Passive investing means you believe in the Efficient Market Hypothesis and you just want to replicate the market returns instead of outperforming it. Active investing entails funds managed actively by fund managers that are trying to outperform the market. In active investing, you believe that you have some advantage over the other participants in the market place and is likely to outperform the market.

In my portfolio, I have both active and passive investments in my core portfolio as I do not believe that all markets are efficient. In developed markets (USA, UK etc), it might be considered a Strong form of Efficient Market Theory as information would be disseminated efficiently to all market participants and thus, by the time news reached any market participant, the price of the asset will have efficiently factored in the value of the news. In developing markets, that might not be the case and there could be a semi-strong or weak form of EMT in play. This means there might be significant knowledge that will not be reflected in the price of the asset efficiently and there are some who can arbitrage in this market (hedge fund managers or proven gurus like Mark Mobius of Templeton Fund).

So, it is good to know your preference and thoughts on investing and then design your portfolios. A good advisor/banker will also be able to profile you and advise you on your portfolio accordingly.

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