Taking a core/satellite approach to fund portfolio construction is sensible. Paul Hookway looks at the options for different markets and assets.
When constructing portfolios for clients, we aim to deliver the best possible performance for the lowest possible cost. A choice between the use of active managers or cheap passive exposure is key to achieving this, but the question is how to make that choice impartially.
In times past, managers looked to populate the portfolio using selected funds from a range of management groups that had outperformed their retrospective peer groups. However, these might not have outperformed the asset allocation benchmark – the FTSE All-Share index, for instance – for several reasons (perhaps because that style of investing was out of favour), meaning the portfolio returned less than it could have done.
With the increasing use of passive funds this is no longer acceptable: if an actively managed fund fails to outperform the required benchmark, we should use a passive in its place. But over what timeframe do we judge a fund’s performance? After much analysis we opted for a rolling three-year period as the basis for our comparison, to ensure the fund manager has a reasonable time to perform and ride out short-term market ups and downs.
This has developed into a ‘core and satellite’ approach, with passive funds forming the core and actively managed funds the satellite. The relative allocation to each section will be driven by active managers’ ability to outperform their benchmark.
Treating the S&P 500 as a fund
To get a clearer idea of how this works, let’s look at an example. By treating the S&P 500 index as a fund, we reviewed which quartile it would be in, relative to the Morningstar US large-cap blend peer group. On a rolling three-year basis, it has been in the middle of the top quartile, though in January it dropped to top of the second quartile.
This suggests that only one in four US large-cap blend funds have outperformed the index over the last three years to the end of January 2019. We can take this a stage further, comparing the S&P 500 to the US large cap value and US large cap growth sectors. On a rolling three-year basis in recent years, actively managed funds (which look for undervalued companies) have been very poor relative to the S&P 500. Growth funds performed better, with several periods where the index would have been in the lower second or upper third quartile relative to the growth fund peer group.
We concluded from this analysis that we should have at least 60% of our US equity allocation in passive funds, with our active managers having a growth bias, as in recent years growth had outperformed value. This review work is ongoing, so we can alter our active/passive split depending on market conditions.
We repeated this research for all the equity allocations in our portfolios. Initially we found that in other markets there were sufficient active managers available that outperform the relevant benchmarks, and so we favoured them over passive funds; but over the last year we have noticed that active managers have been struggling in those markets as well.
UK active managers lose out
This has been most stark in the UK, where heavy trading in certain sectors after the Brexit vote in 2016 and the sharp rally in December 2017 left UK managers lagging over longer timeframes. As a consequence, the FTSE AllShare index is now within the first quartile in the UK large-cap peer group, which forms the core of our UK exposure, so it made sense to replace our large-cap active managers with passive exposure.
That trend has been less pronounced in the Morningstar UK flex-cap sector, where the FTSE AllShare is broadly middle of the second quartile over the past three years. In our UK allocation we have a bias towards flex-cap (or multi-cap) funds; these have a bias towards the mid- and small-cap businesses in the UK market, where there is still a good chance of outperforming the benchmark.
In other areas there is similarly little reason to switch to passive alternatives. In emerging markets and Asia ex-Japan, fewer active funds have outperformed based on the analysis above, but the key successful active managers stand out, while in Europe this analysis suggests there are still plenty of active managers who add value.
What about fixed income? For government bonds exposure we are 100% in passives as there is little room for active-manager outperformance, but for corporate bond exposure in general we still prefer the active approach.
It’s important to recognise that this core/satellite approach may change over time, as it has over the past year in certain markets.
Paul Hookway is senior fund analyst at Kleinwort Hambros.