Lower Costs, Lower Risk � Better Long Term Performance

Thursday, January 10, 2008

10 Reasons "Core & Explore" Investment Strategies Yield Higher Returns

With the advent of Exchange Traded Funds (ETF)s, we believe there is very little reason for the average investor to have an equity portfolio consisting entirely of individual stocks. Using an investment approach called Core/Satellite or Core and Explore, an investor combines an index with individual stocks. Typically an investor might put 50% of his equity portfolio in an ETF that replicates a market index and 50% in individual securities. There is no hard and fast rule about the percentages. However, the greater the percentage of the portfolio invested in the index, the more the portfolio will behave like the overall market.

Most Institution Investors Take a Core/Satellite Approach Although they would not admit it, most portfolio managers, take a Core/Satellite approach when managing their Canadian equity portfolio. Since they are judged against the performance of the overall Canadian market, they are always acutely aware of how much their portfolio resembles and deviates from this benchmark. They will be diversified across all industrial sectors. The part of their portfolio that mirrors the overall market could be considered the "core" and the part of their portfolio that deviates from the overall market can be considered the "satellite" or "explore". When you hear a portfolio manager say that they are trading around their "core" bank holdings or that they are currently overweight oil stocks and underweight technology stocks or that they have a small cap tilt to their portfolio, they are essentially taking a "core and explore" approach.

Reasons to Consider a Core/Satellite Investment Strategy We believe the majority of individual investors who currently hold individual stocks in their portfolio would benefit by holding ETFs as a core holding and individual stocks for the balance of their investment portfolio, for the following 10 reasons: 1. Better Diversification of Risk Typically, the average investor who buys stock tends to have a poorly diversified portfolio. There is often a concentration in sectors or types of stocks with very similar risk characteristics. Using an ETF to buy a "core" position will provide instant diversification and reduce the overall risk of the portfolio.

2. Easier To Monitor and Understand The more stocks in a portfolio, the harder it is to monitor and understand the risks. There are more investment decisions that have to be made and more factors to be considered. With an ETF or Index fund representing a core position, the number of stocks can be decreased, resulting in a portfolio that is easier to monitor and understand. This allows investors to spend less time managing their portfolio and more time looking for money making ideas.

3. More Tax Efficient A portfolio consisting of all stocks will tend to generate more trading activity as the market and investment outlook changes. With more trading activity, more capital gains will be realized and more taxes paid. With a larger proportion of the portfolio in a single core holding, there will be fewer capital gains triggered.

4. Lower Transaction Costs With fewer stocks, there will be fewer trades and fewer commissions paid. The small annual management fee of the ETF representing the core will easily be recouped by the lower commissions. In an account at a full service broker, the reduction of commissions could be dramatic. (This is one of the main reason why investment advisors do not like ETFs, in addition to the fact that unlike mutual funds, they do not pay trailer fees.) 5. A Decrease in Volatility For the typical investor, with an ETF representing a core holding, the overall portfolio will likely be less volatile than one made up entirely of stocks. 6. Allows Investor to Focus His Attention on Money Making Ideas In a well designed, diversified portfolio, an investor will have to invest in sectors or stocks that he does not like, but is required to hold for diversification purposes. Using an ETF for a core position will provide the necessary diversification, allowing the investor to focus on those stocks expected to outperform.

7. Improve Performance of Portfolio After costs, over 50% of professional money managers will, on average, under perform the market. The average individual investor typically fares worse. Therefore, by reducing your stock portfolio and replacing part of it with a core holding of ETFs will more likely than not improve your overall performance, with less risk than before.

8. Asset Mix Changes Become Easier A change in an investor's asset mix is easier to implement by buying and selling an ETF which represents the core position. If an investor wanted to increase his equity exposure, the purchase of additional units of an ETF makes it easy without having to research individual stocks.

9. Can Implement Sophisticated Investment Strategies Investment strategies such as enhanced index strategies, risk budgeting, portfolio insurance, style tilts, hedging strategies, tax loss harvesting etc. become easier to implement with a core and explore approach.

10. Makes You a Better Investor The proper implementation of a core/satellite strategy requires a certain degree of knowledge and understanding about risk, market indices, benchmarks and portfolio management techniques. As investors gain the knowledge and experience of applying a core and explore strategy, they will in the end become better investors.

Conclusion With the array of ETFs available, investors need not own a portfolio made up entirely of individual stocks. Properly implemented, a core and explore investment strategy will result in a better designed portfolio for the typical investor, with lower costs, lower risk and most likely better long term performance.

Warren A. Mackenzie is president of Second Opinion Investment Risk Consultants (www.secondopinions.ca) and the author of A Second Opinion on Your Finances.

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