The evolution of the ETF industry has given investors access to a wide range of strategies to build out a portfolio. With options ranging from “cheap beta” to highly active or thematic strategies, combining ETFs can help advisors achieve the best of both worlds for their clients.
With so many options available today, advisors can use a core satellite investment selection approach to deliver alpha generation for client portfolios while keeping costs and volatility low.
ETFs are particularly well-suited for building out a core satellite strategy, since you have everything you need in the ETF toolbox.
The core of the portfolio is exactly what it suggests—the stable, long-term portion of the portfolio. Some of the most popular vanilla ETFs are well-suited for this portion of the portfolio.
Advisors might select the Vanguard Total Stock Market ETF (VTI) as their domestic equity core position, the iShares Core MSCI EAFE ETF (IEFA) as their international core position, and the iShares Core U.S. Aggregate Bond ETF (AGG) as their fixed income core position.
These ETFs are some of the largest in terms of assets, with high average daily trading volume and tight spreads. They are also some of the cheapest, with many offering exposure to broad asset classes for less than 0.10%.
For domestic equity, an investor might prefer something like the Schwab U.S. Broad Market ETF (SCHB) or the iShares Russell 3000 ETF (IWV). ETFs such as these provide low-cost, cap-weighted exposure to large slices of the market. Typically, this would be a buy-and-hold position.
Since these ETFs passively track popular benchmarks, they are not alpha-seeking. These ETFs are designed to mimic the performance of the index, less the expense ratio of the fund.
The satellite positions within a portfolio will be allocated to ETFs that seek to outperform the core.
ETFs that would be well-suited to round out satellite positions would be sector or thematic ETFs. These could be short-term tactical plays or long-term secular trends that an investor believes will do well no matter the environment.
Typically, these ETFs will have higher expense ratios. If an investor believes biotech stocks are poised to outperform the broad market, they might have a satellite allocation to the SPDR S&P Biotech ETF (XBI). This ETF is over 11 times as expensive as SCHB.
Table courtesy of FactSet
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Thematic ETFs tend to be even pricier, but can offer significant outperformance. An investor who would have supplemented SCHB exposure with the Amplify Online Retail ETF (IBUY) in 2020 would undoubtedly say the 0.65% expense ratio was well worth it.
IBUY outperformed SCHB by 103% during calendar year 2020, as consumers shifted their purchases online due to the pandemic.
How & Why To Combine
By combining core and satellite positions within a portfolio, investors can get the best of both worlds.
The core makes up the bulk of the portfolio, approximately 65-80%, while satellite positions make up the smaller remainder. By using this structure, costs and volatility remain skewed toward the lower side while still maintaining the potential for alpha.
Consider an investor who combines SCHB with the ARK Innovation ETF (ARKK). Highly active strategies such as those from the ARK suite are well-suited as satellite positions within a portfolio. These ETFs tend to perform quite differently than broad market ETFs.
Combining ARKK with something like SCHB can help investors stomach the higher levels of volatility inherent in such strategies while still reaping the alpha-generating benefits.
The weighted expense ratio of an 80/20 combination of these two ETFs is 0.17%. While it is over five times that of SCHB by itself, it is considerably lower than the 0.75% charged by ARKK. Fee-sensitive investors in particular might have an easier time tolerating higher expense ratios of active or thematic strategies if paired with a larger, low-cost position.
Customization Is Key
Some ETFs won’t fit neatly into one side or another. Some might view smart beta ETFs as a core position, while others might think they are better as satellite positions. Commodity ETFs might have a dedicated core position in one investor’s portfolio, while another takes a more tactical approach to allocating to this space.
While this article provides a general guideline, construction of a core satellite approach is flexible and easily customized. An individual’s unique needs and investment goals should be considered when combining ETFs within a portfolio.