Core-and-Satellite

Quite a number of the financial advisors we work with adhere to a core-and-satellite portfolio system.  But what should be the core and what should be the satellite?  Often funds with broad market exposure, usually indexes, are considered to be the core exposure and anything else is part of the satellite.  However, I have often argued that tactical allocation funds (like our Global Macro separate account, or DWAFX and DWTFX), because of their ability to adapt to numerous investing environments, really should be considered part of the core allocation.
Morningstar’s Christine Benz, in her article  What’s a Core Holding, Anyway? addresses the definitional issue of what constitutes a core holding.  According to her thinking:

One commonly held definition of a core holding is that the investment provides broad exposure to a large part of the market and gives you a lot of diversification in a single shot.

This is pretty much the textbook definition.  She goes on to say that a statistic like r-squared can be used to differentiate core from non-core funds.  Steve Raymond in Dorsey, Wright’s Richmond office, for example, has regularly pointed out that most large-cap funds have r-squares near 0.9, indicating a similar profile to the broad market index like the S&P 500.
But then Ms. Benz gets to the heart of the matter:

However, there’s a big problem with strictly defining what’s core by its level of market correlation. Many great investors–in fact, I’d argue, most great investors–couldn’t give a hoot about whether their portfolio or performance tracks that of a broad market benchmark. Instead, they go where the opportunities beckon, regardless of whether they end up heavily skewed toward a single market segment or not. Such investors’ performance may veer significantly from that of broad market indexes at various points in time–sometimes for better, sometimes for worse. They know that getting ahead of the market over the long haul is what matters, and most would probably argue that concepts like R-squared and “tracking error” are the domain of money managers, not real investors.

This is so great that I wish I had written it!  I added the boldface type, because I think what she said is ridiculously important.  Most great investors don’t care about tracking a benchmark.  They care only about long-term performance and they will go wherever they need to go to get it.  That is the essence of a systematic approach to global tactical asset allocation, and exactly why I would argue that it should be classified as part of a portfolio’s core.